**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
 
 **FORM
        10-Q**
 
 x


OF
      THE
      SECURITIES EXCHANGE ACT OF 1934




**For
      the Quarterly Period Ended September 30, 2006**





or





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


OF
      THE
      SECURITIES EXCHANGE ACT OF 1934





For
      the
      Transition Period from
 to







**CAPITAL
      BANK CORPORATION**


*(Exact
      name of registrant as specified in its charter)*








**North
                Carolina**
            
            **000-30062**
            
            **56-2101930***(State
                or other jurisdiction of incorporation or
                organization)*
            
            *(Commission*
              *File
                Number)*
            
            *(IRS
                Employer*
              *Identification
                Number)*





**333
      Fayetteville Street, Suite 700**


**Raleigh,
      North Carolina 27601**


*(Address
      of principal executive offices)*





**(919)
      645-6400**


*(Registrant’s
      telephone number, including area code)*








Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.


Yes x No o





Indicate
      by check mark whether the registrant is 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.


(Check
      one):





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





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


Yes o No x




As
        of November 8, 2006 there were 11,507,167 shares outstanding of the registrant’s
        common stock, no par value.
 **Capital
        Bank Corporation**
 **Form
        10-Q for the Quarterly Period Ended September 30, 2006**
 
 **INDEX**
 
 
 **PART
                  I - FINANCIAL INFORMATION**
              Page
                  No.Item
                  1.Financial
                  StatementsCondensed
                  consolidated statements of financial condition at September 30,
                  2006
                  (Unaudited) and December 31, 2005
              1Condensed
                  consolidated statements of income for the three and nine months
                  ended
                  September 30, 2006 and 2005 (Unaudited)
              2Condensed
                  consolidated statements of changes in shareholders’ equity for the nine
                  months ended September 30, 2006 and 2005 (Unaudited)
              3Condensed
                  consolidated statements of cash flows for the nine months ended
                  September
                  30, 2006 and 2005 (Unaudited)
              4-5Notes
                  to condensed consolidated financial statements (Unaudited)
              6-12Item
                  2. Management’s Discussion and Analysis of Financial Condition and
                  Results of Operations
              12-24Item
                  3. Quantitative and Qualitative Disclosures About Market
                  Risk
              24Item
                  4. Controls and Procedures
              25**PART
                  II - OTHER INFORMATION**Item
                  1. Legal Proceedings
              26Item
                  1A. Risk Factors
              26Item
                  2. Unregistered Sales of Equity Securities and Use of
                  Proceeds
              28Item
                  3. Defaults upon Senior Securities
              28Item
                  4. Submission of Matters to a Vote of Security
                  Holders
              28Item
                  5. Other Information
              28Item
                  6. Exhibits
              29Signatures
              30
 
 
 
 
 
  
   **Capital
        Bank Corporation**
 
 **PART
        I - FINANCIAL INFORMATION**
 
 **Item
        1.**  **Financial
        Statements**
 
 **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**
 **September
        30, 2006 and December 31, 2005**
 September
                  30, 2006
              
              December
                  31, 2005*(Dollars
                  in thousands except share data)*
              
              
              *(Unaudited)***ASSETS**Cash
                  and due from banks:Interest
                  earning
              
              $
              12,679
              
              $
              4,603Noninterest
                  earning
              
              
              38,908
              
              
              30,544Cash
                  held in escrow
              
              
              -
              
              
              33,185Federal
                  funds sold and short term investments
              
              
              20,523
              
              
              8,757Investment
                  securities - available for sale, at fair value
              
              
              189,627
              
              
              149,266Investment
                  securities - held to maturity, at amortized cost
              
              
              11,020
              
              
              12,334Loans
                  - net of unearned income and deferred fees
              
              
              1,003,835
              
              
              668,982Allowance
                  for loan losses
              
              
              (13,894
              )
              
              (9,592
              )Net
                  loans
              
              
              989,941
              
              
              659,390Premises
                  and equipment, net
              
              
              23,354
              
              
              14,868Bank
                  owned life insurance
              
              
              20,408
              
              
              19,857Deposit
                  premium and goodwill, net
              
              
              66,616
              
              
              12,853Deferred
                  tax assets
              
              
              8,098
              
              
              6,305Other
                  assets
              
              
              18,499
              
              
              15,249**Total
                  assets**
              
              $
              1,399,673
              
              $
              960,906**LIABILITIES**Deposits:Demand,
                  noninterest bearing
              
              $
              108,052
              
              $
              77,847Savings
                  and interest bearing demand deposits
              
              
              355,932
              
              
              237,005Time
                  deposits
              
              
              579,771
              
              
              383,628Total
                  deposits
              
              
              1,043,755
              
              
              698,480Repurchase
                  agreements and federal funds purchased
              
              
              28,582
              
              
              14,514Borrowings
              
              
              111,027
              
              
              93,173Short-term
                  debt
              
              
              -
              
              
              30,000Subordinated
                  debentures
              
              
              30,930
              
              
              30,930Other
                  liabilities
              
              
              24,508
              
              
              10,317**Total
                  liabilities**
              
              
              1,238,802
              
              
              877,414**SHAREHOLDERS’
                  EQUITY**Common
                  stock, no par value; 20,000,000 authorized; 11,507,167 and 6,852,156
                  issued and outstanding as of September 30, 2006 and December 31,
                  2005,
                  respectively
              
              
              141,532
              
              
              70,985Retained
                  earnings
              
              
              21,180
              
              
              14,179Accumulated
                  other comprehensive loss
              
              
              (1,841
              )
              
              (1,672
              )**Total
                  shareholders’ equity**
              
              
              160,871
              
              
              83,492**Total
                  liabilities and shareholders’ equity**
              
              $
              1,399,673
              
              $
              960,906
 
 See
        accompanying Notes to Condensed Consolidated Financial
        Statements
  -
            1
            -
  **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF INCOME**
 **Three
        and Nine Months Ended September 30, 2006 and 2005
        (Unaudited)**
 
 Three
                  Months Ended
                September
                  30,
              
              Nine
                  Months Ended
                September
                  30,2006
              
              2005
              
              2006
              
              2005*(Dollars
                  in thousands except share and per share data)*Interest
                  income:Loans
                  and loan fees
              
              $
              19,982
              
              $
              10,993
              
              $
              55,646
              
              $
              31,140Investment
                  securities
              
              
              2,223
              
              
              1,720
              
              
              6,488
              
              
              5,144Federal
                  funds and other interest income
              
              
              463
              
              
              365
              
              
              1,313
              
              
              498**Total
                  interest income**
              
              
              22,668
              
              
              13,078
              
              
              63,447
              
              
              36,782Interest
                  expense:Deposits
              
              
              8,677
              
              
              4,157
              
              
              22,115
              
              
              11,015Borrowings
                  and repurchase agreements
              
              
              2,398
              
              
              1,492
              
              
              6,741
              
              
              4,272**Total
                  interest expense**
              
              
              11,075
              
              
              5,649
              
              
              28,856
              
              
              15,287**Net
                  interest income**
              
              
              11,593
              
              
              7,429
              
              
              34,591
              
              
              21,495Provision
                  (credit) for loan losses
              
              
              (215
              )
              
              (113
              )
              
              446
              
              
              (522
              )**Net
                  interest income after provision (credit) for loan
                  losses**
              
              
              11,808
              
              
              7,542
              
              
              34,145
              
              
              22,017Noninterest
                  income:Service
                  charges and other fees
              
              
              895
              
              
              771
              
              
              2,921
              
              
              2,142Mortgage
                  fees and revenues
              
              
              507
              
              
              554
              
              
              1,525
              
              
              1,212Net
                  gain on sale of securities
              
              
              128
              
              
              -
              
              
              128
              
              
              7Bank
                  owned life insurance
              
              
              183
              
              
              161
              
              
              597
              
              
              385Other
                  noninterest income
              
              
              545
              
              
              304
              
              
              1,714
              
              
              963**Total
                  noninterest income**
              
              
              2,258
              
              
              1,790
              
              
              6,885
              
              
              4,709Noninterest
                  expense:Salaries
                  and employee benefits
              
              
              4,287
              
              
              3,536
              
              
              13,680
              
              
              10,164Occupancy
              
              
              1,044
              
              
              666
              
              
              2,760
              
              
              1,906Furniture
                  and equipment
              
              
              675
              
              
              356
              
              
              1,729
              
              
              1,093Director
                  fees
              
              
              369
              
              
              325
              
              
              1,028
              
              
              717Data
                  processing
              
              
              214
              
              
              301
              
              
              814
              
              
              930Advertising
              
              
              234
              
              
              217
              
              
              813
              
              
              596Amortization
                  of deposit premiums
              
              
              342
              
              
              53
              
              
              1,028
              
              
              160Professional
                  fees
              
              
              290
              
              
              207
              
              
              856
              
              
              739Telecommunications
              
              
              194
              
              
              145
              
              
              579
              
              
              428Other
                  expenses
              
              
              1,420
              
              
              923
              
              
              3,937
              
              
              2,638**Total
                  noninterest expense**
              
              
              9,069
              
              
              6,729
              
              
              27,224
              
              
              19,371**Net
                  income before tax expense**
              
              
              4,997
              
              
              2,603
              
              
              13,806
              
              
              7,355Income
                  tax expense
              
              
              1,730
              
              
              869
              
              
              4,725
              
              
              2,463**Net
                  income**
              
              $
              3,267
              
              $
              1,734
              
              $
              9,081
              
              $
              4,892Earnings
                  per share - basic
              
              $
              0.28
              
              $
              0.26
              
              $
              0.78
              
              $
              0.72Earnings
                  per share - diluted
              
              $
              0.28
              
              $
              0.25
              
              $
              0.78
              
              $
              0.71Weighted
                  average shares:Basic
              
              
              11,611,476
              
              
              6,800,813
              
              
              11,622,442
              
              
              6,762,292Fully
                  diluted
              
              
              11,694,498
              
              
              6,904,321
              
              
              11,708,446
              
              
              6,905,809
 
 See
        accompanying Notes to Condensed Consolidated Financial
        Statements
  -
            2
            -
  **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**
 **Nine
        Months Ended September 30, 2006 and 2005 (Unaudited)**
 
 Shares
                  of
                CommonStock
              
              Common
                Stock
              
              Other
                Comprehensive
                Income
              
              Retained
                Earnings
              
              Total*(Dollars
                  in thousands except share data)***Balance
                  at January 1, 2005**
              
              
              6,612,787
              
              $
              68,341
              
              $
              305
              
              $
              9,092
              
              $
              77,738Repurchase
                  of outstanding common stock
              
              
              (50,000
              )
              
              (892
              )
              
              -
              
              
              -
              
              
              (892
              )Issuance
                  of common stock for services
              
              
              99,258
              
              
              1,588
              
              
              -
              
              
              -
              
              
              1,588Issuance
                  of common stock for options exercised
              
              
              133,659
              
              
              1,241
              
              
              -
              
              
              -
              
              
              1,241Net
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              4,892
              
              
              4,892Other
                  comprehensive loss
              
              
              
              
              
              
              
              
              (1,100
              )
              
              
              
              
              (1,100
              )Comprehensive
                  income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,792Dividends
                  ($0.18 per share)
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,199
              )
              
              (1,199
              )Balance
                  at September 30, 2005
              
              
              6,795,704
              
              $
              70,278
              
              $
              (795
              )
              $
              12,785
              
              $
              82,268**Balance
                  at January 1, 2006**
              
              
              6,852,156
              
              $
              70,985
              
              $
              (1,672
              )
              $
              14,179
              
              $
              83,492Repurchase
                  of outstanding common stock
              
              
              (309,721
              )
              
              (5,038
              )
              
              -
              
              
              -
              
              
              (5,038
              )Issuance
                  of common stock for acquisition of 1st State Bancorp, Inc.
              
              
              4,882,630
              
              
              74,499
              
              
              -
              
              
              -
              
              
              74,499Issuance
                  of common stock for options exercised
              
              
              82,102
              
              
              951
              
              
              -
              
              
              -
              
              
              951Noncash
                  compensation
              
              
              -
              
              
              135
              
              
              -
              
              
              -
              
              
              135Net
                  income
              
              
              -
              
              
              -
              
              
              -
              
              
              9,081
              
              
              9,081Other
                  comprehensive loss
              
              
              
              
              
              
              
              
              (169
              )
              
              
              
              
              (169
              )Comprehensive
                  income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              8,912Dividends
                  ($0.18 per share)
              
              
              -
              
              
              -
              
              
              -
              
              
              (2,080
              )
              
              (2,080
              )Balance
                  at September 30, 2006
              
              
              11,507,167
              
              $
              141,532
              
              $
              (1,841
              )
              $
              21,180
              
              $
              160,871
 
 See
        accompanying Notes to Condensed Consolidated Financial Statements
 
  -
            3
            -
  **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **Nine
        Months Ended September 30, 2006 and 2005 (Unaudited)**
 
 2006
              
              2005*(Dollars
                  in thousands)*Cash
                  flows from operating activities:Net
                  income
              
              $
              9,081
              
              $
              4,892Adjustments
                  to reconcile net income to net cash usedin
                  operating activities:Amortization
                  of deposit premium
              
              
              1.028
              
              
              160Depreciation
              
              
              1,624
              
              
              1,082Net
                  gains on sale of securities available for sale
              
              
              (128
              )
              
              (7
              )(Gain)
                  loss on disposal of premises, equipment and real estate
                  owned
              
              
              (124
              )
              
              -Change
                  in held for sale loans, net
              
              
              (3,890
              )
              
              (5,310
              )Amortization
                  of premiums on securities, net
              
              
              104
              
              
              235Deferred
                  income tax expense
              
              
              4,705
              
              
              794Issuance
                  of stock for compensation
              
              
              -
              
              
              1,588Provision
                  (credit) for loan losses
              
              
              446
              
              
              (522
              )Changes
                  in assets and liabilities:Accrued
                  interest receivable and other assets
              
              
              3,024
              
              
              (6,941
              )Accrued
                  interest payable and other liabilities
              
              
              11,220
              
              
              (78
              )**Net
                  cash provided by (used in) operating activities**
              
              
              27,090
              
              
              (4,107
              )Cash
                  flows from investing activities:Loan
                  (originations) repayments, net
              
              
              (97,506
              )
              
              11,958Additions
                  to premises and equipment
              
              
              (4,094
              )
              
              (1,984
              )Net
                  (purchase) sales of Federal Home Loan Bank stock
              
              
              543
              
              
              (47
              )Purchase
                  of securities available for sale
              
              
              (69,690
              )
              
              (24,262
              )Purchase
                  of securities held to maturity
              
              
              -
              
              
              (1,560
              )Proceeds
                  from maturities of securities available for sale
              
              
              12,542
              
              
              16,370Proceeds
                  from sales of securities available for sale
              
              
              125,992
              
              
              4,399Proceeds
                  from maturities of securities held to maturity
              
              
              1,324
              
              
              2,273Net
                  cash paid in merger transaction
              
              
              (37,541
              )
              
              -Proceeds
                  from sales of premises, equipment and real estate owned
              
              
              1,231
              
              
              726**Net
                  cash (used in) provided by investing activities**
              
              
              (67,199
              )
              
              7,873Cash
                  flows from financing activities:Net
                  increase in deposits
              
              
              73,239
              
              
              48,207Net
                  increase (decrease) in repurchase agreements
              
              
              14,068
              
              
              (4,135
              )Net
                  decrease in borrowings
              
              
              (16,290
              )
              
              (3,795
              )Repayment
                  of short-term debt
              
              
              (30,000
              )
              
              -Distribution
                  of cash held in escrow
              
              
              33,185
              
              
              -Dividends
                  paid
              
              
              (1,800
              )
              
              (1,188
              )Issuance
                  of common stock for options and other plans
              
              
              951
              
              
              1,241Repurchase
                  of common stock
              
              
              (5,038
              )
              
              (892
              )**Net
                  cash provided by financing activities**
              
              
              68,315
              
              
              39,438Net
                  change in cash and cash equivalents
              
              
              28,206
              
              
              43,204Cash
                  and cash equivalents at beginning of period
              
              
              43,904
              
              
              23,011Cash
                  and cash equivalents at end of period
              
              $
              72,110
              
              $
              66,215*(continued
                  on next page)*
 
 See
        accompanying Notes to Condensed Consolidated Financial
        Statements
  -
            4
            -
  **CAPITAL
        BANK CORPORATION**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)**
 **Nine
        Months Ended September 30, 2006 and 2005 (Unaudited)**
  2006
              
              2005*(Dollars
                  in thousands)***Supplemental
                  Disclosure of Cash Flow Information**Transfer
                  of loans and premises and equipment to other real estate
                  owned
              
              $
              2,866
              
              $
              1,417Dividends
                  payable
              
              $
              691
              
              $
              408Cash
                  paid for:Income
                  taxes
              
              $
              371
              
              $
              2,379Interest
              
              $
              28,230
              
              $
              15,123Acquisition
                  of 1st State Bancorp:Fair
                  value of assets acquired
              
              $
              430,131
              
              $
              -Issuance
                  of common stock
              
              $
              74,499
              
              $
              -Cash
                  paid, including transaction costs
              
              $
              46,639
              
              $
              -Liabilities
                  assumed
              
              $
              308,993
              
              $
              -
 
 See
        accompanying Notes to Condensed Consolidated Financial Statements
 
 
  -
            5
            -
  **Notes
        to Condensed Consolidated Financial Statements (Unaudited)**
 
 **1.**  **Significant
        Accounting Policies and Interim Reporting**
 
 The
        accompanying unaudited condensed consolidated financial statements include
        the
        accounts of Capital Bank Corporation (the “Company”) and its wholly owned
        subsidiary, Capital Bank (the “Bank”). In addition, the Company has interests in
        three trusts, Capital Bank Statutory Trust I, II, and III (hereinafter
        collectively referred to as the “Trusts”). The Trusts have not been consolidated
        with the financial statements of the Company. The interim financial statements
        have been prepared in accordance with accounting principles generally accepted
        in the United States of America. They do not include all of the information
        and
        footnotes required by such accounting principles for complete financial
        statements and therefore should be read in conjunction with the audited
        consolidated financial statements and accompanying footnotes in the Company’s
        Annual Report on Form 10-K for the year ended December 31, 2005, as
        amended.
 
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires management to
        make
        estimates and assumptions that affect reported amounts of assets and liabilities
        as well as the amounts of income and expenses during the reporting period.
        Actual results could differ from those estimates.
 
 In
        the opinion of management, all adjustments necessary for a fair presentation
        of
        the financial position and results of operations for the periods presented
        have
        been included and all significant intercompany transactions have been eliminated
        in consolidation. All such adjustments are of a normal and recurring nature.
        Certain amounts reported in prior periods have been reclassified to conform
        to
        the current presentation. Such reclassifications have no effect on net income
        or
        shareholders’ equity as previously reported. The results of operations for the
        three and nine months period ended September 30, 2006 are not necessarily
        indicative of the results of operations that may be expected for the year
        ended
        December 31, 2006.
 
 The
        condensed consolidated balance sheet at December 31, 2005 has been derived
        from
        the audited consolidated financial statements contained in the Company’s Annual
        Report on Form 10-K for the year ended December 31, 2005, as
        amended.
 
 The
        accounting policies followed are as set forth in Note 1 of the Notes to
        Consolidated Financial Statements in the Company’s Annual Report on Form 10-K
        for the year ended December 31, 2005, as amended.
 
 In
        June
        2006, the Financial
        Accounting Standards Board (“ FASB ”) issued
        Interpretation No. 48, “ *Accounting
        for Uncertainty in Income Taxes—an interpretation of FASB Statement No.
        109* ”
(“FIN
        48”). The Interpretation clarifies the accounting for uncertain tax positions
        and requires the Company to recognize management’s best estimate of the impact
        of a tax position only if it is considered “more likely than not,” as defined
        in Statement of Financial Accounting Standards (“ SFAS ”) No. 5, *Accounting
        for Contingencies* ,
        of
        being sustained on audit based solely on the technical merits of the tax
        position. FIN 48 is effective as of the first fiscal year beginning after
        December 15, 2006. The Company is currently evaluating the effect of FIN
        48, but
        does not expect the adoption of FIN 48 to have a material impact on the
        Company’s financial condition or results of operations.
 
 In
        September 2006, the FASB issued SFAS No. 157, *Fair
        Value Measurements* ,
        (“SFAS No. 157”), which defines fair value, establishes a framework for
        measuring fair value, and expands disclosures about fair value measurements.
        SFAS No. 157 will be effective for the Company beginning January 1, 2008.
        The
        Company is currently in the process of evaluating the provisions of SFAS
        No. 157
        and determining how this framework for measuring fair value will affect the
        Company’s current accounting policies and procedures and our financial
        statements. The Company has not determined whether the adoption of SFAS No.
        157
        will have a material impact on the Company’s financial
        condition or results of operations .
  In
        September 2006, the FASB issued SFAS No. 158, “ *Employers’
        Accounting for Defined Benefit Pension and Other Postretirement Plans—an
        amendment of FASB Statements No. 87, 88, 106, and 132(R)”* (“SFAS
        No. 158”). SFAS No. 158 requires employers to recognize a net liability or asset
        and an offsetting adjustment to accumulated other comprehensive income to
        report
        the funded status of defined benefit pension and other post-retirement benefit
        plans. SFAS No. 158 requires prospective application; thus, the recognition
        and
        disclosure requirements are effective for fiscal years ending after December
        31,
        2006. Additionally, SFAS No. 158 requires companies to measure plan assets
        and
        obligations at their year-end balance sheet date. This requirement is effective
        for the Company’s fiscal year ending after December 31, 2008. The Company is
        currently evaluating the effect of SFAS No. 158, but does not expect the
        adoption of SFAS No. 158 to have a material impact on the Company’s financial
        condition or results of operations.
  -
            6
            -
   In
        September 2006, the Securities and Exchange Commission (the “ SEC ”) issued
        Staff Accounting Bulletin No. 108, *“Considering
        the Effects of Prior Year Misstatements when Quantifying Misstatements in
        Current Year Financial Statements”* (“SAB
        108”). SAB 108 provides guidance on how prior year misstatements should be taken
        into consideration when quantifying misstatements in current year financial
        statements for purposes of determining whether the current year’s financial
        statements are materially misstated. SAB 108 permits registrants to record
        the
        cumulative effect of initial adoption by recording the necessary “correcting”
adjustments to the carrying values of assets and liabilities as of the beginning
        of that year with the offsetting adjustment recorded to the opening balance
        of
        retained earnings only if material under the dual method. SAB 108 is effective
        for fiscal years ending on or after November 15, 2006. The Company does not
        expect the adoption of SAB 108 to have a material impact on the Company’s
        financial condition or results of operations.
 
 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. The Company considers the effect of the
        proposed statements on the financial statements of the Company and monitors
        the
        status of changes to and proposed effective dates of exposure
        drafts.
 
 **2.**   **Acquisition
        of 1st State Bancorp**
 
 On
        January 3, 2006, the Company completed its acquisition of all the outstanding
        capital stock of 1st State Bancorp, Inc. (“1st State Bancorp”), the holding
        company for 1st State Bank. (“1st State Bank”). The total purchase price was
        approximately $121.1 million, including transaction costs of $6.3 million.
        The
        Company issued approximately 4.9 million shares of common stock and paid
        $40.3
        million in cash in exchange for 100% of 1st State Bancorp’s outstanding common
        stock and stock options. The transaction was accounted for under the purchase
        method of accounting and is intended to qualify as a tax-free reorganization
        under Section 368(a) of the Internal Revenue Code.
 
 An
        unaudited summary of the preliminary estimated fair values of assets acquired
        and liabilities assumed is as follows:
 *(Dollars
                  in thousands)*Loans
                  receivable, net of allowance for loan losses
              
              $
              230,600Investment
                  securities
              
              
              110,007Premises
                  and equipment
              
              
              7,925Deposit
                  premium
              
              
              5,331Goodwill
              
              
              49,460Other
                  assets
              
              
              26,808Deposits
              
              
              (272,037
              )Borrowings
              
              
              (34,144
              )Other
                  liabilities
              
              
              (2,812
              )Investment
                  in subsidiary, net of dividends to shareholders and capitalized
                  acquisition costs
              
              $
              121,138
 
 The
        following unaudited pro forma financial information presents the combined
        results of operations of the Company and 1st State Bancorp as if the merger
        had
        occurred as of the beginning of the period for each period presented. The
        pro
        forma financial information does not necessarily reflect the results of
        operations that would have occurred had the Company and 1st State Bancorp
        constituted a single entity during such periods.
 
 Three
                  Month PeriodEnded
                  September 30, 2005
              
              Nine
                  Month PeriodEnded
                  September 30, 2005*(Dollars
                  in thousands except per share data)*Net
                  interest income
              
              $
              10,435
              
              $
              30,262Noninterest
                  income
              
              $
              2,263
              
              $
              6,138Noninterest
                  expense
              
              $
              9,251
              
              $
              26,985Net
                  income
              
              $
              2,194
              
              $
              6,079Net
                  income per common share - basic
              
              $
              0.19
              
              $
              0.52Net
                  income per common share - diluted
              
              $
              0.19
              
              $
              0.52
 
  -
            7
            -
  **3.**   **Comprehensive
        Income**
 
 Comprehensive
        income includes net income and all other changes to the Company’s equity, with
        the exception of transactions with shareholders (“other comprehensive income”).
        The Company’s comprehensive income for the nine months periods ended September
        30, 2006 and 2005 are as shown in the Company’s Condensed Consolidated
        Statements of Changes in Shareholders’ Equity for the nine months ended
        September 30, 2006 and 2005 (unaudited). The Company’s only components of other
        comprehensive income relate to unrealized gains and losses on available for
        sale
        securities, net of the applicable income tax effect and are as
        follows:
 
 2006
              
              2005*(Dollars
                  in thousands)*
              
              *(Unaudited)***Three
                  Month Period Ended September 30, 2006 and 2005**Unrealized
                  gains (losses) on available for sale securities
              
              $
              2,438
              
              $
              (1,060
              )Reclassification
                  of gains recognized in net income
              
              
              (128
              )
              
              -Income
                  tax benefit (expense)
              
              
              (891
              )
              
              408Other
                  comprehensive income (loss)
              
              $
              1,419
              
              $
              (652
              )**Nine
                  Month Period Ended September 30, 2006 and 2005**Unrealized
                  losses on available for sale securities
              
              $
              (147
              )
              $
              (1,783
              )Reclassification
                  of gains recognized in net income
              
              
              (128
              )
              
              (7
              )Income
                  tax benefit
              
              
              106
              
              
              690Other
                  comprehensive loss
              
              $
              (169
              )
              $
              (1,100
              )
 
 **4.**   **Earnings
        Per Share**
 
 The
        Company is required to report both basic and diluted earnings per share (“EPS”).
        Basic EPS excludes dilution and is computed by dividing income available
        to
        common shareholders by the weighted average number of common shares outstanding
        for the period. Diluted EPS assumes the conversion, exercise or issuance
        of all
        potential common stock instruments, such as stock options, unless the effect
        is
        to reduce a loss or increase earnings per share. For the Company, EPS is
        adjusted for outstanding stock options using the treasury stock method in
        order
        to compute diluted EPS. The following tables provide a computation and
        reconciliation of basic and diluted EPS for the three and nine month periods
        ended September 30, 2006 and 2005, respectively:
 
 2006
              
              2005*(Dollars
                  in thousands except share data)*
              
              *(Unaudited)***Three
                  Month Period Ended September 30, 2006 and 2005**Income
                  available to shareholders - basic and diluted
              
              $
              3,267
              
              $
              1,734Shares
                  used in the computation of earnings per share:Weighted
                  average number of shares outstanding - basic
              
              
              11,611,476
              
              
              6,800,813Incremental
                  shares from assumed exercise of stock options
              
              
              83,022
              
              
              103,508Weighted
                  average number of shares outstanding - diluted
              
              
              11,694,498
              
              
              6,904,321**Nine****Month Period Ended September 30, 2006 and 2005**Income
                  available to shareholders - basic and diluted
              
              $
              9,081
              
              $
              4,892Shares
                  used in the computation of earnings per share:Weighted
                  average number of shares outstanding - basic
              
              
              11,622,442
              
              
              6,762,292Incremental
                  shares from assumed exercise of stock options
              
              
              86,004
              
              
              143,517Weighted
                  average number of shares outstanding - diluted
              
              
              11,708,446
              
              
              6,905,809
 
 For
        the three and nine month periods ended September 30, 2006 and 2005, options
        to
        purchase approximately 345,470 shares and 458,015 shares, respectively, of
        common stock were used in the diluted calculation. For the three and nine
        month
        periods ended September 30, 2006 and 2005, options to purchase approximately
        65,250 shares and 80,850 shares ,
        respectively, of common stock were not included in the diluted calculation
        because the option price exceeded the average fair market value of the
        associated shares of common stock.
  -
            8
            -
  **5.**  **Stock-Based
        Compensation**
  Effective
        January 1, 2006, the Company adopted the fair value recognition provisions
        of
        SFAS No. 123R, *Share-Based
        Payments* (“SFAS
        No. 123R”), using the modified prospective transition method. Under that
        transition method, compensation cost recognized in 2006 includes: (a)
        compensation cost for all share-based payments granted prior to, but not
        yet
        vested as of January 1, 2006, based on the grant date fair value estimated
        in accordance with the original provisions of SFAS No. 123, *Accounting
        for Stock-Based Compensation* (“SFAS
        No. 123”) and (b) compensation cost for all share-based payments granted
        subsequent to December 31, 2005, based on the grant date fair value
        estimated in accordance with the provisions of SFAS No. 123R.
 
 Effective January
        1, 2006, the Company began recognizing the cost of all new employee share-based
        awards on a straight-line basis over their respective vesting periods, net
        of
        estimated forfeitures. The Company previously accounted for stock options
        using
        the intrinsic value method in accordance with the provisions of APB Opinion
        No.
        25 (“APB 25”), *Accounting
        for Stock Issued to Employees* ,
        and SFAS No. 123. Under SFAS No. 123, the Company was required to disclose
        the
        pro forma effects on net income as if it had recorded compensation based
        on the
        fair value of options granted. For the three and nine month periods ended
        September 30, 2005, the Company disclosed net income and earnings per share,
        as
        reported and pro forma, as follows:
  **Three
                    Month Period Ended September 30, 2005***(Dollars
                    in thousands except per share data)*Net
                    income
                
                
                As
                    reported
                
                $
                1,734Pro
                    forma
                
                $
                1,701Net
                    income per share - basic
                
                
                As
                    reported
                
                $
                0.26Pro
                    forma
                
                $
                0.25Net
                    income per share - diluted
                
                
                As
                    reported
                
                $
                0.25Pro
                    forma
                
                $
                0.25
  **Nine Month
                    Period Ended September 30, 2005***(Dollars
                    in thousands except per share data)*Net
                    income
                
                
                As
                    reported
                
                $
                4,892Pro
                    forma
                
                $
                4,773Net
                    income per share - basic
                
                
                As
                    reported
                
                $
                0.72Pro
                    forma
                
                $
                0.71Net
                    income per share - diluted
                
                
                As
                    reported
                
                $
                0.71Pro
                    forma
                
                $
                0.70
  On
        December 29, 2005, the Compensation/Human Resources Committee of the Board
        of
        Directors of the Company approved the acceleration of vesting of all the
        outstanding unvested stock options awarded under the Company’s Equity Incentive
        Plan. As a result, options to purchase 67,200 shares of the Company’s common
        stock, which would otherwise have vested from time to time over the next
        five
        years, became immediately exercisable on December 30, 2005. As a result of
        the
        acceleration of vesting, approximately $331,000 of future compensation expense
        that would have been recognized in operating results under SFAS No. 123R
        over
        the next five years was eliminated. Accordingly, the adoption of SFAS No.
        123R
        did not have a material impact on the Company’s operating results or financial
        condition.
 
 The
        Company has stock option plans providing for the issuance of up to 650,000
        options to purchase shares of the Company’s common stock to officers and
        directors. At September 30, 2006, options for 186,709 shares of common stock
        remained available for future issuance. In addition, there were approximately
        567,000 options which were assumed under various plans from previously acquired
        financial institutions, of which approximately 138,666 remain outstanding.
        Grants of options are made by the Board of Directors or its Compensation/Human
        Resources Committee. All grants must be at no less than fair market value
        on the
        date of grant, must be exercised no later than 10 years from the date of
        grant,
        and may be subject to certain vesting provisions. There were no new stock
        option
        grants in the nine months ended September 30, 2006 and all options outstanding
        as of September 30, 2006 were fully vested.
 
  -
            9
            -
  The
        Company also administers the Capital Bank Corporation Deferred Compensation
        Plan
        for Outside Directors (“Deferred Compensation Plan”). Under the Deferred
        Compensation Plan, eligible directors may elect to defer all or part of their
        directors’ fees for a calendar year, in exchange for common stock of the
        Company, based on the year-end share price. The amount deferred, if elected,
        is
        equal to 125 percent of their total director’s fees. Each participant is fully
        vested in his account balance. The Deferred Compensation Plan generally provides
        for payment of share units either in shares of Company common stock or
        cash (at the Company’s option) after the participant ceases to serve as a
        director for any reason. The Deferred Compensation Plan is classified as
        a
        liability-based plan under SFAS No. 123R. For the three and nine month periods
        ended September 30, 2006, the Company recognized $86,000 and $181,000,
        respectively, of share-based expense related to the Deferred Compensation
        Plan.
 
 The
        following is a summary of stock option information and the weighted average
        exercise price (“WAEP”) for the nine months ended September 30,
        2006:
  Shares
              
              WAEPOutstanding
                  at January 1, 2006
              
              
              495,822
              
              $
              11.65Granted
              
              
              -
              
              
              -Exercised
              
              
              (82,102
              )
              
              11.59Terminated
              
              
              (12,832
              )
              
              10.57Outstanding
                  at September 30, 2006
              
              
              400,888
              
              $
              11.69Options
                  exercisable at September 30, 2006
              
              
              400,888
              
              $
              11.69
 
 The
        following table summarizes information about the Company’s stock options at
        September 30, 2006:
 Exercise
                  Price
              
              Number
                Outstanding
              
              Weighted
                  AverageRemaining
                  Contractual Life
                in
                  Years
              
              Number
                Exercisable$6.62
                  - $9.00
              
              
              135,538
              
              
              3.67
              
              
              135,538$9.01
                  - $12.00
              
              
              102,223
              
              
              4.59
              
              
              102,223$12.01
                  - $15.00
              
              
              33,750
              
              
              2.27
              
              
              33,750$15.01
                  - $18.00
              
              
              69,127
              
              
              6.47
              
              
              69,127$18.01
                  - $18.37
              
              
              60,250
              
              
              8.24
              
              
              60,250400,888
              
              
              4.95
              
              
              400,888
 
 The
        fair values of the options granted prior to January 1, 2006 had been estimated
        on the date of the grants using the Black-Scholes option-pricing model. Option
        pricing models require the use of highly subjective assumptions, including
        expected stock volatility, which when changed can materially affect fair
        value
        estimates. The expected life of the options used in this calculation was
        the
        period the options are expected to be outstanding. Expected stock price
        volatility was based on the historical volatility of the Company’s common stock
        for a period approximating the expected life, the expected dividend yield
        was
        based on the Company’s historical annual dividend payout, and the risk-free rate
        was based on the implied yield available on U.S. Treasury issues. The following
        weighted-average assumptions were used in the determining fair value for
        options
        granted in the quarter ended September 30, 2006 and 2005,
        respectively:
 
 2006
              
              2005Dividend
                  yield
              
              
              -
              
              
              1.31
              %Expected
                  volatility
              
              
              -
              
              
              27.17
              %Risk-free
                  interest rate
              
              
              -
              
              
              4.03
              %Expected
                  life
              
              
              -
              
              
              7
                  years
 
  -
            10
            -
  **6.**  **Investment
        Securities**
 
 The
        following table shows the gross unrealized losses and fair value of the
        Company’s investments with unrealized losses that are not deemed to be
        other-than-temporarily impaired, aggregated by investment category and length
        of
        time that individual securities have been in a continuous unrealized loss
        position, at September 30, 2006:
  Less
                    than 12 Months
                
                12
                    Months or Greater
                
                TotalFair
                    Value
                
                Unrealized
                    Losses
                
                Fair
                    Value
                
                Unrealized
                    Losses
                
                Fair
                    Value
                
                Unrealized
                    Losses(*Dollars
                    in thousands)***Description
                    of Security***Available
                    for sale*Direct
                    obligations of U.S. government agencies
                
                $
                22,509
                
                $
                74
                
                $
                36,160
                
                $
                977
                
                $
                58,669
                
                $
                1,051Municipal
                    bonds
                
                
                7,814
                
                
                28
                
                
                3,940
                
                
                111
                
                
                11,754
                
                
                139Mortgage-backed
                    securities
                
                
                11,867
                
                
                66
                
                
                58,488
                
                
                2,044
                
                
                70,355
                
                
                2,11042,190
                
                
                168
                
                
                98,588
                
                
                3,132
                
                
                140,778
                
                
                3,300*Held
                    to maturity*Direct
                    obligations of U.S. government agencies
                
                
                -
                
                
                -
                
                
                3,895
                
                
                101
                
                
                3,895
                
                
                101Municipal
                    bonds
                
                
                -
                
                
                -
                
                
                286
                
                
                14
                
                
                286
                
                
                14Mortgage-backed
                    securities
                
                
                -
                
                
                -
                
                
                6,495
                
                
                228
                
                
                6,495
                
                
                228-
                
                
                -
                
                
                10,676
                
                
                343
                
                
                10,676
                
                
                343Total
                    at September 30, 2006
                
                $
                42,190
                
                $
                168
                
                $
                109,264
                
                $
                3,475
                
                $
                151,454
                
                $
                3,643
 The
        unrealized losses on the Company‘s investments in direct obligations of U.S.
        government agencies and mortgage-backed securities were primarily the result
        of
        interest rate changes. Mortgage-backed securities include securities issued
        by
        government agencies and corporate entities. The Company has the ability and
        intent to hold these investments until a recovery of fair value, which may
        be
        maturity. Accordingly, the Company does not consider these investments to
        be
        other-than-temporarily impaired at September 30, 2006.
 
 **7.**  L **oans**
 
 The
        composition of the loan portfolio by loan classification at September 30,
        2006
        and December 31, 2005 is as follows:
 
 September
                  30,2006
              
              December
                  31, 2005*(Dollars
                  in thousands)*Commercial
              
              $
              825,122
              
              $
              555,198Consumer
              
              
              35,621
              
              
              26,222Home
                  equity lines
              
              
              88,806
              
              
              65,566Residential
                  mortgages
              
              
              54,219
              
              
              21,8631,003,768
              
              
              668,849Plus
                  deferred loan costs, net
              
              
              67
              
              
              133$
              1,003,835
              
              $
              668,982
 
 Loans
        held for sale as of September 30, 2006 and December 31, 2005 were $8.2 million
        and $4.2 million, respectively, and were included in the residential mortgage
        category.
 
 **8.**  **Financial
        Instruments with Off-Balance Sheet Risk**
 
 To
        meet the financial needs of its customers, the Company is party to financial
        instruments with off-balance sheet risk in the normal course of business.
        These
        financial instruments are comprised of unused lines of credit and standby
        letters of credit. These instruments involve, to varying degrees, elements
        of
        credit risk in excess of the amount recognized in the balance
        sheet.
  -
            11
            -
  The
        Company’s exposure to credit loss in the event of nonperformance by the other
        party is represented by the contractual amount of those instruments. The
        Company
        uses the same credit policies in making these commitments as it does for
        on-balance sheet instruments. The amount of collateral obtained, if deemed
        necessary by the Company, upon extension of credit is based on management’s
        credit evaluation of the borrower. Collateral held varies but may include
        trade
        accounts receivable, property, plant, and equipment and income-producing
        commercial properties. Since many unused lines of credit expire without being
        drawn upon, the total commitment amounts do not necessarily represent future
        cash requirements.
 
 The
        Company’s exposure to credit risk was as follows:
 September
                  30,2006
              
              December
                  31, 2005*(Dollars
                  in thousands)*Unused
                  lines of credit
              
              $
              280,747
              
              $
              188,170Standby
                  letters of credit
              
              
              6,412
              
              
              8,563Total
                  commitments
              
              $
              287,159
              
              $
              196,733
 
 
 **Item
        2.**  **Management’s
        Discussion and Analysis of Financial Condition and Results of
        Operations**
 
 The
        following discussion presents an overview of the unaudited financial statements
        for the three and nine months periods ended September 30, 2006 and 2005 for
        Capital Bank Corporation (the “Company”) and it’s wholly owned subsidiary,
        Capital Bank (the “Bank”). This discussion and analysis is intended to provide
        pertinent information concerning financial condition ,
        results of operations, liquidity, and capital resources for the periods covered
        and should be read in conjunction with the unaudited financial statements
        and
        related footnotes contained in Part I, Item 1. of this report.
 
 *Information
        set forth below contains various forward-looking statements within the meaning
        of Section 27A of the Securities Act of 1933, as amended, and Section 21E
        of the
        Securities Exchange Act of 1934, as amended (the “Exchange Act”), which
        statements represent the Company’s judgment concerning the future and are
        subject to risks and uncertainties that could cause the Company’s actual
        operating results to differ materially. Such forward-looking statements can
        be
        identified by the use of forward-looking terminology, such as “may,” “will,”
“expect,” “anticipate,” “estimate,” “believe,” or “continue,” or the negative
        thereof or other variations thereof or comparable terminology. The Company
        cautions that such forward-looking statements are further qualified by important
        factors that could cause the Company’s actual operating results to differ
        materially from those in the forward-looking statements, as well as the factors
        set forth in Part II, Item 1A of this report, and the Company’s periodic reports
        and other filings with the SEC.*
 
 ***Overview***
 
 The
        Bank is a full-service state chartered community bank conducting business
        throughout North Carolina. The Bank’s business consists principally of
        attracting deposits from the general public and investing these funds in
        loans
        secured by commercial real estate, secured and unsecured commercial and consumer
        loans, single-family residential mortgage loans, and home equity lines. As
        a
        community bank, the Bank’s profitability depends primarily upon its levels of
        net interest income, which is the difference between interest income from
        interest-earning assets and interest expense on interest-bearing liabilities.
        When interest-earning assets approximate or exceed interest-bearing liabilities,
        any positive interest rate spread will generate net interest income. The
        Bank’s
        profitability is also affected by its provision for loan losses, noninterest
        income, and other operating expenses. Noninterest income primarily consists
        of
        miscellaneous service charges and ATM fees, fees generated from originating
        mortgage loans that are sold and the increase in cash surrender value of
        bank-owned life insurance. Operating expenses primarily consist of compensation
        and benefits, occupancy related expenses, advertising, data processing,
        professional fees, telecommunication and other expenses.
 
 The
        Bank’s operations are influenced significantly by local economic conditions and
        by policies of financial institution regulatory authorities. The Bank’s cost of
        funds is influenced by interest rates on competing investments and by rates
        offered on similar investments by competing financial institutions in our
        market
        area, as well as general market interest rates. Lending activities are affected
        by the demand for financing, which in turn is affected by the prevailing
        interest rates.
 
  -
            12
            -
  ***Critical
        Accounting Policies and Estimates***
 
 The
        Company’s significant accounting policies are described in Note 1 of the
        Company’s Annual Report on Form 10-K for the year ended December 31, 2005, as
        amended, on pages 40-46. These policies are important in understanding
        management’s discussion and analysis. Some of the Company’s accounting policies
        require the Company to make estimates and judgments regarding uncertainties
        that
        may affect the reported amounts of assets, liabilities, revenues and
        expenses.
 
 The
        Company has identified five accounting policies as being critical in terms
        of
        significant judgments and the extent to which estimates are used: allowance
        for
        loan losses, investments, valuation allowances, goodwill and the impairment
        of
        long-lived assets. In many cases, there are several alternative judgments
        that
        could be used in the estimation process. The Company bases its estimates
        on
        historical experience and on various other assumptions that are believed
        to be
        reasonable under the circumstances, the results of which form the basis for
        making judgments about the carrying values of assets and liabilities that
        are
        not readily apparent from other sources. Actual results may differ from these
        estimates under different assumptions or conditions. For more information
        on the
        Company’s critical accounting policies, refer to pages 17-18 of the Company’s
        Annual Report on Form 10-K for the year ended December 31, 2005, as
        amended.
 
 ***Executive
        Summary***
 
 As
        discussed in more detail below, the following is a brief summary of
        our significant results for the quarter ended September 30, 2006:
 
 l
              The
                  Company reported net income for the quarter ended September 30,
                  2006 of
                  $3.3 million compared to $1.7 million for the quarter ended September
                  30,
                  2005. Fully diluted earnings per share were $0.28 and $0.25 for
                  the
                  quarter ended September 30, 2006 and 2005,
                  respectively.
 
 l
              The
                  increase in net income was primarily due to a $4.2 million increase
                  in net
                  interest income, which reflects the addition of the assets and
                  liabilities
                  acquired in the 1st State Bancorp merger transaction and a 34 basis
                  point
                  increase in the net interest margin, offset by a $2.3 million increase
                  in
                  noninterest expenses, which includes the costs associated with
                  the
                  assimilation of 1st State Bancorp’s employees and operations into the
                  Company.
 
 l
              The
                  credit for loan losses for the quarter ended September 30, 2006
                  was
                  $215,000 compared to a credit in the quarter ended September 30,
                  2005 of
                  $113,000. The decrease in the credit for loan losses is primarily
                  due to
                  net recoveries for the quarter offset by the estimated inherent
                  losses
                  associated with the net growth in the loan portfolio during the
                  quarter
                  ended September 30, 2006. Net recoveries for the quarter ended
                  September
                  30, 2006 were $102,000, or 0.04% of average loans, compared to
                  net
                  charge-offs of $118,000, or 0.07% of average loans, for the quarter
                  ended
                  September 30, 2005.
 
 l
              Net
                  interest income for the quarter ended September 30, 2006 rose to
                  $11.6
                  million, a 56.1% increase over the $7.4 million reported in the
                  quarter
                  ended September 30, 2005. The Company’s net interest margin widened to
                  3.91%, a 34 basis point increase over the quarter ended September
                  30,
                  2005. The increase in net interest income is primarily due to the
                  incremental effects of 1st State Bancorp’s interest-earning assets and
                  interest-bearing liabilities, higher organic loanand
                  deposit growth forthe quarter ended September 30, 2006 compared to the quarter ended
                  September 30, 2005 and the current level of interest
                  rates.
 
 l
              Noninterest
                  income for the quarter ended September 30, 2006 increased $0.5
                  million to
                  $2.3 million compared to $1.8 million in the quarter ended September
                  30,
                  2005. This increase is primarily due to higher service charges
                  and other
                  fees as a result of a higher volume of transaction accounts, including
                  those acquired in the 1st State Bancorp transaction, $208,000 related
                  to
                  distributions from two limited partner investments, and $128,000
                  in net
                  gains realized on the sale of investment
                  securities.
 
 l
              Noninterest
                  expense was $9.1 million for the quarter ended September 30, 2006
                  compared
                  to $6.7 million for the quarter ended September 30, 2005. The increase
                  is
                  primarily due to higher salaries and employee benefits, which increased
                  by
                  $0.8 million in the quarter ended September 30, 2006 compared to
                  the
                  quarter ended September 30, 2005. The increase in salaries and
                  employee
                  benefits was primarily due to an increase in the number of personnel
                  employed by the Company as a result of the 1st State Bancorp transaction
                  and the transition to in-house operations as well as higher costs
                  associated with the Company’s
                  growth.
 
  -
            13
            -
  ***Financial
        Condition***
 
 Total
        consolidated assets of the Company at September 30, 2006 were $1.4 billion
        compared to $960.9 million at December 31, 2005, an increase of $438.8 million,
        or approximately 46%. The increase in total consolidated assets for the nine
        month period ended September 30, 2006 is primarily due to a $330.6 million
        increase in the Bank’s loan portfolio, net of the allowance for loan losses,
        since December 31, 2005, which includes $230.6 million of net loans acquired
        in
        the 1st State Bancorp transaction. Total deposits as of September 30, 2006
        were
        $1.04 billion, which represents growth of $345.3 million from December 31,
        2005
        and includes $267.0 million of total deposits acquired in the 1st State Bancorp
        transaction.
  Total
          earning assets were $1.24 billion at September 30, 2006 compared to $843.9
          million at December 31, 2005. Earning assets represented 88.4% and 87.8%
          of
          total assets as of September 30, 2006 and December 31, 2005, respectively.
          At
          September 30, 2006, investment securities were $200.6 million, which includes
          $7.8 million of investment securities acquired in the 1st State Bancorp
          transaction, compared to $161.6 million at December 31, 2005, an increase
          of
          $39.0 million due to new investment security purchases. Interest-earning
          cash,
          federal funds sold and short term investments were $33.2 million at September
          30, 2006, an increase of $19.8 million from December 31, 2005. The Company
          has
          increased its holdings of short-term investment assets to maintain liquidity
          for
          loan fundings and future commitments. As of December 31, 2005, the Company
          had
          $33.1 million of cash held in escrow, which represented funds the Company
          was
          required to deposit with its transfer agent for payment to 1st State Bancorp
          shareholders as cash consideration in connection with the 1st State Bancorp
          merger transaction. Earning assets exclude bank owned life insurance, which
          increased from $19.9 million at December 31, 2005 to $20.4 million at September
          30, 2006 due to the increase in cash surrender values.
 
 The
        allowance for loan losses as of September 30, 2006 was $13.9 million and
        represented approximately 1.38% of total loans at September 30, 2006. The
        allowance for loan losses increased $4.3 million from the December 31, 2005
        balance of $9.6 million. The increase is primarily due to the addition of
        1st
        State Bank’s $7.6 million allowance for loan losses offset by $3.8 million of
        net charge-offs during the first nine months of 2006. Management believes
        that
        the amount of the allowance is adequate to absorb the estimated probable
        losses
        inherent in the current loan portfolio. See *“Asset
        Quality”* for further discussion of the allowance for loan losses ***.***
 
 Total
        deposits as of September 30, 2006 were $1.04 billion, an increase of $345.3
        million, or 49.4%, from December 31, 2005. The increase was primarily due
        to the
        infusion of
        $267.0 million of deposits acquired in the 1st State Bancorp transaction
        and
        organic deposit growth as a result of the Company’s focus on growing core
        deposits. As of September 30, 2006, the Company experienced an increase of
        $160.6 million, or 45.6%, in certificates of deposit (“CDs”) compared to
        December 31, 2005, which includes $139.8 million of CDs acquired in the 1st
        State Bancorp transaction. Total time deposits represented 55.5% of total
        deposits at September 30, 2006 compared to 54.9% at December 31, 2005. The
        Company introduced a new high yield checking account product, *Smart
        Checking* ,
        during the second quarter of 2006. This product is designed to generate higher
        debit card interchange income to offset the higher yield offered. As of
        September 30, 2006, there were 3,178 *Smart
        Checking* accounts and $13.3 million of deposits associated with this new
        product.
 
 Noninterest
        bearing demand deposit accounts (“DDA”) were $108.1 million at September 30,
        2006, an increase of $30.2 million, or 38.8%, from December 31, 2005, which
        includes $19.8 million of noninterest bearing deposits acquired in the 1st
        State
        Bancorp transaction. The average balance of noninterest DDA accounts was
        $99.6
        million during the quarter ended September 30, 2006 compared to $76.7 million
        during the quarter ended September 30, 2005.
 
 Total
        consolidated shareholders’ equity was $160.9 million as of September 30, 2006,
        an increase of $77.4 million from December 31, 2005. The Company issued 4.9
        million shares of common stock valued at $74.5 million in connection with
        the
        1st State Bancorp transaction. For the nine month period ended September
        30,
        2006, the Company repurchased 309,721 shares of its common stock at an aggregate
        cost of $5.0 million. See Part II - Other Information, Item 2. Unregistered
        Sales of Equity Securities and Use of Proceeds for more information on the
        Company’s share repurchases. Retained earnings increased by $7.0 million
        reflecting $9.1 million of net income for the nine months period ended September
        30, 2006 less $2.1 million of dividends paid during the nine months ended
        September 30, 2006. Accumulated other comprehensive loss, which represents
        the
        unrealized loss on available for sale securities, net of related tax benefits,
        was $1.8 million, an increase of $0.2 million for the nine months period
        ended
        September 30, 2006, which is due to the effect that rising interest rates
        have
        on the fair value of the Company’s investment security portfolio. See Item 1.
        Financial Statements - Consolidated Statements of Changes in Shareholders’
Equity for additional information.
  -
            14
            -
  ***Results
        of Operations***
 
 Quarter
        ended September 30, 2006 compared to quarter ended September 30,
        2005
 
 For
        the quarter ended September 30, 2006, the Company reported net income of $3.3
        million, or $0.28 per diluted share, compared to net income of $1.7 million,
        or
        $0.25 per diluted share, for the quarter ended September 30, 2005. Net income
        increased by $1.5 million primarily due to higher loan and deposit balances
        on
        which net interest income and noninterest income are generated offset by
        higher
        operating expenses. The increased balances were primarily the result of the
        1st
        State Bancorp transaction combined with organic loan and deposit growth.
        The
        Company’s net interest margin also improved in the quarter ended September 30,
        2006 compared to the quarter ended September 30, 2005 as a result of the
        higher
        interest rates and the Company’s asset-sensitive position. The net interest
        margin, on a tax equivalent basis, for the quarter ended September 30, 2006
        decreased by 13 basis points compared to the net interest margin for the
        quarter
        ended June 30, 2006. The Company expects further net interest margin compression
        in the near term and is taking steps to mitigate its exposure to interest
        rate
        volatility, including entering into a three year $100 million (notional)
        interest rate swap transaction in October 2006 that will be accounted for
        as a
        cash flow hedge.
 
 Net
        interest income increased $4.2 million, or 56.1%, from $7.4 million for the
        quarter ended September 30, 2005, to $11.6 million for the quarter ended
        September 30, 2006. Average earning assets increased $369.0 million to $1.21
        billion for the quarter ended September 30, 2006 from $844.0 million for
        the
        quarter ended September 30, 2005. Average interest bearing liabilities increased
        $339.7 million to $1.09 billion for the quarter ended September 30, 2006
        from
        $753.5 million for the quarter ended September 30, 2005. The net interest
        margin
        on a fully taxable equivalent basis increased by 34 basis points to 3.91%
        for
        the quarter ended September 30, 2006 from 3.57% for the quarter ended September
        30, 2005. The earned yield on average interest earnings assets was 7.53%
        and
        6.22% for the quarter ended September 30, 2006 and 2005, respectively, while
        the
        interest rate on average interest bearing liabilities for those periods was
        4.02% and 2.97%, respectively. The increase in the net interest margin is
        primarily attributed to increases in the benchmark federal funds rates as
        determined by the Federal Reserve Open Market Committee (“FOMC”). The Company’s
        balance sheet remains asset sensitive and, as a result, its interest earning
        assets reprice faster than its interest bearing liabilities. The Company
        cannot
        be certain of the direction of the benchmark federal funds rates as set by
        the
        FOMC. The FOMC did not change the benchmark federal funds rate during the
        quarter ended September 30, 2006. The Company expects its effective cost
        of
        interest bearing liabilities will increase during the quarter ended December
        31,
        2006 as a result of increased competition for funds in the Company’s primary
        markets.
 
 The
        following table shows the Company’s effective yield on earning assets and cost
        of funds. Yields and costs are computed by dividing income or expense for
        the
        year by the respective daily average asset or liability balance.
 
  -
            15
            -
  **Average
        Balances, Interest Earned or Paid, and Interest
        Yields/Rates**
 **Three
        Months Ended September 30, 2006 and 2005**
 Taxable
        Equivalent Basis 1
 2006
              
              2005*(Dollars
                  in thousands)*
              
              
              Average
                  Balance
              
              
              Amount
                  Earned
              
              
              Average
                  Rate
              
              
              Average
                  Balance
              
              
              Amount
                  Earned
              
              
              Average
                  Rate**Assets**Loans
                  receivable:2Commercial
              
              $
              806,005
              
              $
              16,432
              
              
              8.09
              %
              $
              519,300
              
              $
              8,920
              
              
              6.81
              %Consumer
              
              
              30,910
              
              
              701
              
              
              9.00
              %
              
              31,686
              
              
              635
              
              
              7.95
              %Home
                  equity
              
              
              90,618
              
              
              1,965
              
              
              8.60
              %
              
              60,697
              
              
              1,011
              
              
              6.61
              %Residential
                  mortgages3
              
              
              54,504
              
              
              882
              
              
              6.42
              %
              
              26,060
              
              
              427
              
              
              6.50
              %Total
                  loans
              
              
              982,037
              
              
              19,980
              
              
              8.07
              %
              
              637,743
              
              
              10,993
              
              
              6.84
              %Investment
                  securities4
              
              
              195,323
              
              
              2,586
              
              
              5.25
              %
              
              162,282
              
              
              1,884
              
              
              4.61
              %Federal
                  funds sold and other interest on short-term investments
              
              
              35,642
              
              
              463
              
              
              5.15
              %
              
              43,967
              
              
              365
              
              
              3.29
              %Total
                  interest earning assets
              
              
              1,213,002
              
              $
              23,029
              
              
              7.53
              %
              
              843,992
              
              $
              13,242
              
              
              6.22
              %Cash
                  and due from banks
              
              
              32,094
              
              
              
              
              
              
              
              
              24,759Other
                  assets
              
              
              133,897
              
              
              
              
              
              
              
              
              63,453Allowance
                  for loan losses
              
              
              (13,161
              )
              
              
              
              
              
              
              
              (10,062
              )Total
                  assets
              
              $
              1,365,832
              
              
              
              
              
              
              
              $
              922,142**Liabilities
                  and Equity**Savings
                  deposits
              
              $
              38,137
              
              $
              48
              
              
              0.50
              %
              $
              16,831
              
              $
              22
              
              
              0.52
              %Interest-bearing
                  demand deposits
              
              
              304,355
              
              
              2,521
              
              
              3.29
              %
              
              213,824
              
              
              1,090
              
              
              2.02
              %Time
                  deposits
              
              
              578,018
              
              
              6,107
              
              
              4.19
              %
              
              389,925
              
              
              3,045
              
              
              3.10
              %Total
                  interest-bearing deposits
              
              
              920,510
              
              
              8,676
              
              
              3.74
              %
              
              620,580
              
              
              4,157
              
              
              2.66
              %Borrowed
                  funds
              
              
              110,164
              
              
              1,402
              
              
              5.05
              %
              
              99,648
              
              
              1,073
              
              
              4.27
              %Subordinated
                  debt
              
              
              30,930
              
              
              619
              
              
              7.94
              %
              
              20,620
              
              
              331
              
              
              6.37
              %Repurchase
                  agreements
              
              
              31,562
              
              
              378
              
              
              4.75
              %
              
              12,605
              
              
              88
              
              
              2.77
              %Total
                  interest-bearing liabilities
              
              
              1,093,166
              
              $
              11,075
              
              
              4.02
              %
              
              753,453
              
              $
              5,649
              
              
              2.97
              %Noninterest-bearing
                  deposits
              
              
              99,633
              
              
              
              
              
              
              
              
              76,731Other
                  liabilities
              
              
              11,132
              
              
              
              
              
              
              
              
              10,352Total
                  liabilities
              
              
              1,203,931
              
              
              
              
              
              
              
              
              840,536Shareholders’
                  equity
              
              
              161,901
              
              
              
              
              
              
              
              
              81,606Total
                  liabilities and shareholders’ equity
              
              $
              1,365,832
              
              
              
              
              
              
              
              $
              922,142Net
                  interest spread5
              
              
              
              
              
              
              
              
              3.51
              %
              
              
              
              
              
              
              
              3.25
              %Tax
                  equivalent adjustment
              
              
              
              
              $
              363
              
              
              
              
              
              
              
              $
              164Net
                  interest income and net interest margin6
              
              
              
              
              $
              11,954
              
              
              3.91
              %
              
              
              
              $
              7,593
              
              
              3.57
              %
 
 1 The taxable equivalent basis is computed using a blended federal and state
        tax
        rate of approximately 38%.
 2 Loans receivable include nonaccrual loans for which accrual of interest has
        not
        been recorded.
 3 Includes loans held for sale.
 4 The average balance for investment securities excludes the effect of their
        mark-to-market adjustment, if any.
 5 Net interest spread represents the difference between the average yield on
        interest-earning assets and the average cost of interest-bearing
        liabilities.
 6 Net interest margin represents net interest income divided by average
        interest-earning assets.
  -
            16
            -
  Interest
        income on loans increased from $11.0 million for the quarter ended September
        30,
        2005 to $20.0 million for the quarter ended September 30, 2006. The increase
        is
        primarily due to higher average loan balances, which increased by $344.3
        million
        primarily due to loan balances acquired in the 1st State Bancorp transaction
        and
        organic loan growth, and higher loan yields. Yields on commercial, consumer,
        and
        home equity increased 128 basis points, 105 basis points and 199 basis points,
        respectively, in the quarter ended September 30, 2006 compared to the quarter
        ended September 30, 2005. Higher yields in 2006 reflect the increase in the
        prime rate charged by the Bank between those two periods. Variable rate loans
        made up approximately 70% of the total loan portfolio at September 30, 2006
        and
        2005.
 
 Interest
        income on investment securities increased from $1.7 million for the quarter
        ended September 30, 2005 to $2.2 million for the quarter ended September
        30,
        2006. The increase is primarily due to an increase in average balances
        outstanding between the periods, which increased by $33.0 million. The yield
        on
        investment securities on a tax-equivalent basis increased from 4.61% in the
        quarter ended September 30, 2005 to 5.25% in the quarter ended September
        30,
        2006. The increase is primarily due to higher yields on new investment
        securities purchases as a result of the higher interest rate environment
        in 2006
        compared to 2005.
 
 Interest
        expense on deposits increased from $4.2 million for the quarter ended September
        30, 2005 to $8.7 million for the quarter ended September 30, 2006. The increase
        is primarily due to an increase in the average balance of interest bearing
        deposits outstanding, which increased $299.9 million primarily due to deposit
        balances acquired in the 1st State Bancorp transaction and organic deposit
        growth, and higher deposit rates. The average rate paid on time deposits
        increased from 3.10% for the quarter ended September 30, 2005 to 4.19% for
        the
        quarter ended September 30, 2006, a 109 basis point rise, as new certificates
        were opened at higher rates due to the rising interest rate environment.
        Rates
        on shorter maturity CDs have increased significantly with the FOMC interest
        rate
        increases and management anticipates the Bank’s CD funding costs will continue
        to increase in the fourth quarter of 2006.
 
 Interest
        expense on borrowings increased from $1.5 million for the quarter ended
        September 30, 2005 to $2.4 million for the quarter ended September 30, 2006.
        The
        increase is primarily due to higher outstanding borrowing and subordinated
        debt
        balances and an increase in interest rates. The rate on borrowings and
        subordinated debentures for the quarter ended September 30, 2006 increased
        to
        5.05% and 7.94%, respectively, from 4.27% and 6.37%, respectively, for the
        quarter ended September 30, 2005. In July of 2003, the Bank entered into
        interest rate swap agreements on $25.0 million of its outstanding Federal
        Home
        Loan Bank advances to swap fixed rate borrowings to a variable rate. In the
        quarter ended September 30, 2005, the net effect of the swaps was a reduction
        of
        interest expense, however, as a result of the significant increase in short-term
        interest rates, the net effect of the swaps was an increase in interest expense
        for the quarter ended September 30, 2006. As short-term interest rates have
        increased following the FOMC rate increases, the overall effective rate on
        both
        borrowings and subordinated debt has increased.
 
 For
        the quarter ended September 30, 2006, the credit for loan losses was $215,000
        compared to a credit of $113,000 for the quarter ended September 30, 2005,
        a
        decrease of $102,000. The decrease in the credit for loan losses was primarily
        due to net recoveries of $102,000 and the estimated inherent losses associated
        with the net growth in the loan portfolio during the quarter ended September
        30,
        2006 and other factors as discussed more fully below under “ *Asset
        Quality.”* Net
        charge-offs (recoveries) for the quarter ended September 30, 2006 were
        ($102,000), or (0.04%) of average loans, compared to $118,000, or 0.07% of
        average loans, for the quarter ended September 30, 2005.
 
 Noninterest
        income for the quarter ended September 30, 2006 was $2.3 million compared
        to
        $1.8 million for the quarter ended September 30, 2005, an increase of $0.5
        million. This increase was primarily due to a $124,000 increase in service
        charges and other fees as a result of a higher volume of transaction accounts,
        which were acquired in the 1st State Bancorp transaction, $208,000 related
        to
        distributions from two limited partner investments and $128,000 of net capital
        gains generated from investment security sales.
 
 Noninterest
        expense for the quarter ended September 30, 2006 was $9.1 million compared
        to
        $6.7 million for the quarter ended September 30, 2005. Salaries and employee
        benefits, representing the largest noninterest expense category, increased
        to
        $4.3 million for the quarter ended September 30, 2006, from $3.5 million
        for the
        quarter ended September 30, 2005. The increase was primarily due to an increase
        in the number of personnel employed by the Company as a result of the 1st
        State
        Bancorp transaction and the transition to in-house operations and increased
        benefit costs, offset by reductions in incentive compensation and supplemental
        retirement plan accruals. As of September 30, 2006, the Company had 322
        full-time equivalent employees compared to 247 at September 30, 2005 and
        256 at
        December 31, 2005.
 
  -
            17
            -
  Occupancy
        costs, the second largest component of noninterest expenses, increased $378,000
        to $1.0 million for the quarter ended September 30, 2006 from $666,000 for
        the
        quarter ended September 30, 2005. The increase is primarily due to expenses
        associated with branches acquired in the 1st State Bancorp transaction and
        higher rent expense related to the Company’s new headquarters. Furniture and
        equipment expenses for the quarter ended September 30, 2006 increased $319,000
        from the same period in 2005 primarily due to higher equipment maintenance
        costs
        associated with the increase in branch locations and higher depreciation
        associated with computer equipment acquired for the Company’s operations center.
        Data processing expenses for the quarter ended September 30, 2006 decreased
        $87,000 from the same period in 2005 primarily due to a reduction in external
        item processing costs as a result of bringing operations in-house in 2006.
        The
        Company anticipates data processing costs will continue to decrease in future
        periods as a result of consolidating the transaction processing at its
        operations center in Burlington, North Carolina.
 
 Deposit
        premium amortization for the quarter ended September 30, 2006 increased $289,000
        from the same period in 2005 primarily as a result of the deposit premium
        intangible associated with the 1st State Bancorp transaction, which was valued
        at $5.3 million as of the closing date and is being amortized over eight
        years.
        Professional fees for the quarter ended September 30, 2006 increased $83,000
        from the same period in 2005 primarily due to higher legal fees and consulting
        expenses. Other expenses for the quarter ended September 30, 2006 increased
        $497,000 from the same period in 2005 primarily due to increased costs
        associated with operational losses, travel and entertainment and office supplies
        and printing, which increased by $111,000, $122,000 and $103,000,
        respectively.
 
 The
        Company’s effective tax rate for the quarter ended September 30, 2006 was 34.6%
        compared to 33.4% for the same period in 2005. The increase in the effective
        rate is primarily due to lower proportion of tax exempt income to taxable
        income
        for the quarter ended September 30, 2006 compared to the same period in 2005.
        Income tax expense for the quarter ended September 30, 2006 and 2005 was
        $1.7
        million and $0.9 million respectively. The Company forecasts its taxable
        and
        non-taxable income and calculates the effective tax rate for the entire year,
        which is then applied to the three month period.
 
 ***Results
        of Operations***
 
 Nine
        month periods ended September 30, 2006 and 2005
 
 For
        the nine month period ended September 30, 2006, the Company reported net
        income
        of $9.1 million, or $0.78 per diluted share, compared to net income of $4.9
        million, or $0.71 per diluted share, for the nine month period ended September
        30, 2005. Net income increased by $4.2 million primarily due to higher net
        interest income, which increased as a result of higher loan and deposit balances
        acquired in the 1st State Bancorp transaction and organic loan and deposit
        growth, an
        improved net interest margin and higher noninterest income offset by higher
        noninterest expenses.
 
 Net
        interest income increased $13.1 million, or 60.9%, from $21.5 million for
        the
        nine month period ended September 30, 2005, to $34.6 million for the nine
        month
        period ended September 30, 2006. Average earning assets increased $353.4
        million
        to $1.18 billion for the nine month period ended September 30, 2006 from
        $827.8
        million for the nine month period ended September 30, 2005. Average interest
        bearing liabilities increased $317.4 million to $1.06 billion for the nine
        month
        period ended September 30, 2006 from $740.2 million for the nine month period
        ended September 30, 2005. The net interest margin on a fully taxable equivalent
        basis increased 45 basis points to 4.00% for the nine month period ended
        September 30, 2006 from 3.55% for the nine month period ended September 30,
        2005. The earned yield on average interest earnings assets was 7.27% and
        6.02%
        for the nine month periods ended September 30, 2006 and 2005, respectively,
        while the interest rate on average interest bearing liabilities for those
        same
        periods was 3.65% and 2.76%, respectively. The increase in the net interest
        margin is primarily due to higher loan yields, which increased from 6.44%
        for
        the nine month period ended September 30, 2005 to 7.80% for the nine month
        period ended September 30, 2006 offset partially by higher deposits interest
        rates, which increased from 2.44% for the nine month period ended September
        30,
        2005 to 3.33% for the nine month period ended September 30, 2006. The increase
        in loan yields and deposit interest rates is primarily attributed to increases in
        the
        benchmark federal funds rates as determined by the FOMC.
 
 The
        following table shows the Company’s effective yield on earning assets and cost
        of funds. Yields and costs are computed by dividing income or expense for
        the
        year by the respective daily average asset or liability balance.
 
  -
            18
            -
  **Average
        Balances, Interest Earned or Paid, and Interest
        Yields/Rates**
 **Nine
        Months Ended September 30, 2006 and 2005**
 Taxable
        Equivalent Basis 1
 2006
              
              2005*(Dollars
                  in thousands)*
              
              
              Average
                  Balance
              
              
              Amount
                  Earned
              
              
              Average
                  Rate
              
              
              Average
                  Balance
              
              
              Amount
                  Earned
              
              
              Average
                  Rate**Assets**Loans
                  receivable:2Commercial
              
              $
              772,893
              
              $
              45,211
              
              
              7,82
              %
              $
              527,204
              
              $
              25,316
              
              
              6.42
              %Consumer
              
              
              30,272
              
              
              1,977
              
              
              8.73
              %
              
              31,606
              
              
              1,796
              
              
              7.60
              %Home
                  equity
              
              
              95,696
              
              
              5,754
              
              
              8.04
              %
              
              61,455
              
              
              2,839
              
              
              6.18
              %Residential
                  mortgages3
              
              
              54,608
              
              
              2,704
              
              
              6.62
              %
              
              25,882
              
              
              1,189
              
              
              6.14
              %Total
                  loans
              
              
              953,469
              
              
              55,646
              
              
              7.80
              %
              
              646,147
              
              
              31,140
              
              
              6.44
              %Investment
                  securities4
              
              
              193,301
              
              
              7,234
              
              
              5.00
              %
              
              160,400
              
              
              5,635
              
              
              4.70
              %Federal
                  funds sold and other interest on short-term
                investments
              
              
              34,434
              
              
              1,313
              
              
              5.10
              %
              
              21,225
              
              
              498
              
              
              3.14
              %Total
                  interest earnings assets
              
              
              1,181,204
              
              $
              64,193
              
              
              7.27
              %
              
              827,772
              
              $
              37,273
              
              
              6.02
              %Cash
                  and due from banks
              
              
              31,890
              
              
              
              
              
              
              
              
              23,501Other
                  assets
              
              
              134,935
              
              
              
              
              
              
              
              
              58,881Allowance
                  for loan losses
              
              
              (14,869
              )
              
              
              
              
              
              
              
              (10,410
              )Total
                  assets
              
              $
              1,333,160
              
              
              
              
              
              
              
              $
              899,744**Liabilities
                  and Equity**Savings
                  deposits
              
              $
              41,143
              
              $
              160
              
              
              0.52
              %
              $
              16,607
              
              $
              63
              
              
              0.51
              %Interest-bearing
                  demand deposits
              
              
              283,023
              
              
              6,051
              
              
              2.86
              %
              
              194,156
              
              
              2,576
              
              
              1.77
              %Time
                  deposits
              
              
              563,420
              
              
              15,904
              
              
              3.77
              %
              
              392,365
              
              
              8,376
              
              
              2.85
              %Total
                  interest-bearing deposits
              
              
              887,586
              
              
              22,115
              
              
              3.33
              %
              
              603,128
              
              
              11,015
              
              
              2.44
              %Borrowed
                  funds
              
              
              110,750
              
              
              4,015
              
              
              4.85
              %
              
              102,336
              
              
              3,119
              
              
              4.07
              %Subordinated
                  debt
              
              
              31,478
              
              
              1,812
              
              
              7.70
              %
              
              20,620
              
              
              912
              
              
              5.91
              %Repurchase
                  agreements
              
              
              27,766
              
              
              914
              
              
              4.40
              %
              
              14,139
              
              
              241
              
              
              2.28
              %Total
                  interest-bearing liabilities
              
              
              1,057,580
              
              $
              28,856
              
              
              3.65
              %
              
              740,223
              
              $
              15,827
              
              
              2.76
              %Noninterest-bearing
                  deposits
              
              
              101,705
              
              
              
              
              
              
              
              
              69,007Other
                  liabilities
              
              
              12,854
              
              
              
              
              
              
              
              
              10,918Total
                  liabilities
              
              
              1,172,139
              
              
              
              
              
              
              
              
              820,148Shareholders’
                  equity
              
              
              161,021
              
              
              
              
              
              
              
              
              79,596Total
                  liabilities and shareholders’ equity
              
              $
              1,333,160
              
              
              
              
              
              
              
              $
              899,744Net
                  interest spread5
              
              
              
              
              
              
              
              
              3.62
              %
              
              
              
              
              
              
              
              3.26
              %Tax
                  equivalent adjustment
              
              
              
              
              $
              746
              
              
              
              
              
              
              
              $
              491Net
                  interest income and net interest margin
              
              
              
              
              $
              35,337
              
              
              4.00
              %
              
              
              
              $
              21,986
              
              
              3.55
              %
 
 1
              The
                  taxable equivalent basis is computed using a blended federal and
                  state tax
                  rate of approximately 38%.
 2
              Loans
                  receivable include nonaccrual loans for which accrual of interest
                  has not
                  been recorded.
 3
              Includes
                  loans held for sale.
 4
              The
                  average balance for investment securities excludes the effect of
                  their
                  mark-to-market adjustment, if any.
 5
              Net
                  interest spread represents the difference between the average yield
                  on
                  interest-earning assets and the average cost of interest-bearing
                  liabilities.
 6
              Net
                  interest margin represents net interest income divided by average
                  interest-earning assets.
  -
            19
            -
  For
        the nine month period ended September 30, 2006, the provision for loan losses
        was $446,000 compared to a credit of $522,000 for the nine month period ended
        September 30, 2005, an increase of approximately $1.0 million. The increase
        in
        2006 was primarily due to the overall net growth of the loan portfolio and
        the
        related estimated inherent losses in the portfolio and higher net charge-offs.
        The Company revised its allowance for loan loss estimation methodology during
        the nine month period ended September 30, 2005 related to specific loan loss
        allocations, which reduced the allowance for loan losses in 2005. Net
        charge-offs for the nine month period ended September 30, 2006 were $3.8
        million
        compared to $355,000 for the nine month period ended September 30, 2005.
        Net
        charge-offs for the nine months period ended September 30, 2006 includes
        $2.9
        million related to one 1st State Bank loan relationship that had been fully
        reserved by 1st State Bank as of December 31, 2005 and had no impact on the
        Bank’s loan loss provision for the nine months period ended September 30, 2006.
        See *“Asset
        Quality”* below for further discussion of the allowance for loan losses.
 
 Noninterest
        income for the nine month period ended September 30, 2006, was $6.9 million
        compared to $4.7 million for the nine month period ended September 30, 2005,
        an
        increase of $2.2 million. Deposit service charges and fees increased by $779,000
        as a result of a higher volume of transaction accounts, including accounts
        acquired in the 1st State Bancorp transaction. Mortgage fees and revenues
        increased by $313,000 primarily due to higher loan volumes and bank owned
        life
        insurance increased by $212,000 due to additional insurance purchased during
        the
        second quarter of 2005. Other noninterest income increased by $751,000 primarily
        due to higher brokerage income, which increased $237,000 due to higher
        investment product sales, $208,000 in distributions from two limited partner
        investments and a $138,000 gain on the sale of consolidated branch locations.
        The Company recognized $128,000 of net gains generated from investment security
        sales for the nine month period ended September 30, 2006 compared to $7,000 for
        the nine month period ended September 30, 2005.
 
 Noninterest
        expense for the nine month period ended September 30, 2006 was $27.2 million
        compared to $19.4 million for the nine month period ended September 30, 2005.
        Salaries and employee benefits, representing the largest noninterest expense
        category, increased by $3.5 million to $13.7 million for the nine month period
        ended September 30, 2006, from $10.2 million for the nine month period ended
        September 30, 2005. This increase reflects an increase in the number of
        personnel employed by the Company as a result of the 1st State Bancorp
        transaction and the transition to in-house operations and increased benefit
        costs, offset by reductions in supplemental retirement plan
        accruals.
 
 Occupancy
        costs and furniture and equipment expenses for the nine month period ended
        September 30, 2006 increased by $854,000 and $636,000, respectively, compared
        to
        the nine month period ended September 30, 2005 primarily due to the 1st State
        Bancorp transaction, which increased the number of branches in the Company’s
        network and higher expenses associated with the Company’s new headquarters.
        Directors’ fees increased $311,000 for the nine month period ended September 30,
        2006 compared to the same period in 2005 primarily due to higher expense
        accruals associated with the directors’ supplemental retirement plan and the
        directors’ deferred compensation plan as a result of the adoption of SFAS No.
        123R. Data processing expenses decreased $116,000 for the nine month period
        ended September 30, 2005 compared to the same period in 2005 primarily due
        to a
        reduction in external item processing costs as a result of bringing operations
        in-house in 2006. Advertising expenses for the nine month period ended September
        30, 2006 increased by $217,000 compared to the same period in 2005 primarily
        due
        to costs associated with the promotion of a new checking account product
        and the
        opening of the Company’s new headquarters. Deposit premium amortization for the
        nine month period ended September 30, 2006 increased $868,000 compared to
        the
        same period in 2005 primarily due to the deposit premium intangible associated
        with the 1st State Bancorp transaction. Professional fees for the nine month
        period ended September 30, 2006 increased by $117,000 compared to the same
        period in 2005 primarily due to higher legal and accounting fees and higher
        consulting expenses associated with the integration of 1st State Bank. Other
        expenses for the nine month period ended September 30, 2006 increased $1.3
        million from the same period in 2005 primarily due to higher costs associated
        with operational losses, travel and entertainment, and office supplies and
        printing, which increased $217,000, $285,000 and $307,000,
        respectively.
 
 The
        Company’s effective tax rate for the nine months ended September 30, 2006 and
        2005 was 34.2% and 33.5%, respectively. The change in the effective tax rate
        was
        due to changes in forecasted levels of taxable and tax exempt income and
        the
        increase for these comparable periods primarily reflects a lower mix of tax
        exempt income. The Company recorded income tax expense of $4.7 million and
        $2.5
        million for the nine month periods ended September 30, 2006 and 2005,
        respectively.
 
  -
            20
            -
  ***Asset
        Quality***
 
 Determining
        the allowance for loan losses is based on a number of factors, many of which
        are
        subject to judgments made by management. At the origination of each commercial
        loan, management assesses the relative risk of the loan and assigns a
        corresponding risk grade. To ascertain that the credit quality is maintained
        after the loan is booked, the Bank has a procedure whereby a loan review
        officer
        performs an annual review of all unsecured loans over a predetermined loan
        amount, a sampling of loans within a lender’s authority, and a sampling of the
        entire loan pool. Loans are reviewed for credit quality, sufficiency of credit
        and collateral documentation, proper loan approval, covenant, policy and
        procedure adherence, and continuing accuracy of the loan grade. This officer
        reports directly to the Chief Credit Officer and the Audit Committee of the
        Company’s Board of Directors. On an as needed basis, the Bank will hire an
        outside third party firm to review the Bank’s loan portfolio to ensure quality
        standards and reasonableness of risk assessment.
 
 The
        Company estimates the amount of allowance needed to cover probable inherent
        losses in the portfolio by applying a loss allowance factor to each risk
        grade.
        Consumer loans and mortgages are not risk graded, but a loss allocation factor
        is utilized for these loans based on historical losses. The loss allocation
        factors have been developed based on the Bank’s historical losses and industry
        trends. In addition to this quantitative analysis, a qualitative assessment
        of
        the general economic trends, portfolio concentration and the trend of
        delinquencies are taken into consideration. The loan loss allowance is adjusted
        to an amount that management believes is adequate to absorb probable losses
        inherent in the loan portfolio as of the balance sheet date
        presented.
 
 Beginning
        in the second quarter of 2005, the Company began estimating a specific allowance
        for loan losses associated with certain commercial loans risk-rated 5 or
        worse
        with outstanding balances greater than $750,000. Management determines the
        level
        of specific allowance based on the facts and circumstances of each loan,
        including among other factors, payment history, collateral values, guarantor
        liquidity, and net worth. Of the $13.9 million allowance for loan losses
        as of
        September 30, 2006, $2.6 million has been allocated to specific
        loans.
 
 The
        allowance for loan losses is established through a provision for loan losses
        charged to expense. Loans are charged against the allowance for loan losses
        when
        management believes that the collectibility of the principal is unlikely.
        Based
        on this allowance calculation, management recorded a credit of $215,000 for
        the
        quarter ended September 30, 2006, compared to a credit of $113,000 for the
        quarter ended September 30, 2005. The Company added 1st State Bank’s allowance
        for loan losses, which was $7.6 million as of December 31, 2005, to the
        Company’s allowance for loan losses. The Company continued to see overall
        favorable improvements in key risk metrics and trends associated with the
        credit
        quality of loan portfolio during the quarter ended September 30, 2006. Past
        due
        loans as a percentage of the average loans increased slightly from 0.96%
        at June
        30, 2006 to 0.97% at September 30, 2006. Past dues greater than 90 days as
        a
        percentage of total loans was 0.44% and 0.48% at September 30, 2006 and June
        30,
        2006, respectively. Nonaccrual loans as a percentage of loans was 0.61% and
        0.65% at September 30, 2006 and June 30, 2006, respectively.
  The
        following table presents an analysis of changes in the allowance for loan
        losses
        for the three and nine month periods ended September 30, 2006 and 2005,
        respectively:
 
  -
            21
            -
  
 Three
                  Months Ended September 30,
              
              Nine
                  Months Ended September 30,2006
              
              2005
              
              2006
              
              2005*(Dollars
                  in thousands)*Allowance
                  for loan losses, beginning of period
              
              $
              14,007
              
              $
              10,075
              
              $
              9,592
              
              $
              10,7211st
                  State Bank loan loss allowance acquired
              
              
              -
              
              
              -
              
              
              7,637
              
              
              -Net
                  charge-offs:Loans
                  charged off:Commercial
              
              
              114
              
              
              116
              
              
              3,961
              
              
              212Consumer
              
              
              118
              
              
              12
              
              
              254
              
              
              292Home
                  equity lines
              
              
              29
              
              
              -
              
              
              55
              
              
              -Mortgage
              
              
              68
              
              
              34
              
              
              102
              
              
              144Total
                  charge-offs
              
              
              329
              
              
              162
              
              
              4,3721
              
              
              648Recoveries
                  of loans previously charged off:Commercial
              
              
              376
              
              
              27
              
              
              501
              
              
              251Consumer
              
              
              10
              
              
              17
              
              
              36
              
              
              42Home
                  equity
              
              
              27
              
              
              -
              
              
              31
              
              
              -Mortgage
              
              
              18
              
              
              -
              
              
              23
              
              
              -Total
                  recoveries
              
              
              431
              
              
              44
              
              
              591
              
              
              293Total
                  net charge-offs (recoveries)
              
              
              (102
              )
              
              118
              
              
              3,7811
              
              
              355Loss
                  provisions (credit) charged to operations
              
              
              (215
              )
              
              (113
              )
              
              446
              
              
              (522
              )Allowance
                  for loan losses, end of period
              
              $
              13,894
              
              $
              9,844
              
              $
              13,894
              
              $
              9,844Net
                  charge-offs (recoveries) to average loans during the period
                  (annualized)
              
              
              (0.04
              %)
              
              0.07
              %
              
              0.53%1
              
              
              0.07
              %Allowance
                  as a percent of gross loans
              
              
              1.38
              %
              
              1.54
              %
 
 1 Net
        charge-offs for the nine month period ended September 30, 2006 includes $2.9
        million related to one 1st State Bank loan relationship that was fully reserved
        by 1st State Bank as of December 31, 2005. Excluding the $2.9 million net
        charge-off, the ratio of net charge-offs to average loans during the nine
        month
        period ending September 30, 2006 was 0.12%.
 
 The
        following table presents an analysis of nonperforming assets as of September
        30,
        2006 and 2005 and December 31, 2005:
  September
                  30,2006
              
              September
                  30,2005
              
              December
                  31, 2005*(Dollars
                  in thousands)*Nonaccrual
                  loans:Commercial
                  and commercial real estate
              
              $
              3,885
              
              $
              3,915
              
              $
              5,040Mortgage
              
              
              1,453
              
              
              1,711
              
              
              1,628Construction
              
              
              71
              
              
              1,302
              
              
              737Equity
                  lines
              
              
              440
              
              
              592
              
              
              497Consumer
              
              
              259
              
              
              239
              
              
              176Total
                  nonaccrual loans
              
              
              6,108
              
              
              7,759
              
              
              8,078Foreclosed
                  property held
              
              
              637
              
              
              1,608
              
              
              771Total
                  nonperforming assets
              
              $
              6,745
              
              $
              9,367
              
              $
              8,849Nonperforming
                  assets to total loans
              
              
              0.67
              %
              
              1.20
              %
              
              1.32
              %Nonperforming
                  assets to total assets
              
              
              0.48
              %
              
              1.01
              %
              
              0.92
              %Allowance
                  coverage of nonperforming loans
              
              
              227
              %
              
              127
              %
              
              119
              %
 
  -
            22
            -
  At
        September 30, 2006, nonperforming assets were $6.7 million, a decrease of
        $2.1
        million from December 31, 2005. The majority of the Company’s nonperforming
        loans are secured by real estate and to a lesser extent the Company relies
        on
        the support of guarantors. The Company monitors the value of the underlying
        collateral and the liquidity of the guarantors on a periodic basis. Based
        on
        this review and analysis, the Company does not currently anticipate any material
        losses associated with the nonperforming loans existing at September 30,
        2006.
 
 A
        loan is considered impaired, based on current information and events, if
        it is
        probable that the Bank will be unable to collect the scheduled payments of
        principal and interest when due according to the contractual terms of the
        loan
        agreement. Uncollateralized loans are measured for impairment based on the
        present value of expected future cash flows discounted at the historical
        effective interest rate, while all collateral-dependent loans are measured
        for
        impairment based on the fair value of the collateral. There were no impaired
        loans at September 30, 2006 and December 31, 2005.
 
 The
        Bank uses several factors in determining if a loan is impaired. Internal
        asset
        classification procedures include a review of significant loans and lending
        relationships by both management and third party credit review firms and
        includes the accumulation of related data such as loan payment status,
        borrowers’ financial data and borrowers’ operating factors such as cash flows,
        operating income or loss. The Company’s determination of the allowance for loan
        losses is subject to management’s judgment and analysis of many internal and
        external factors. While management is comfortable with the adequacy of the
        current allowance, changes in factors and management’s future evaluation of the
        adequacy of the allowance for loan losses will change.
 
 Foreclosed
        property decreased to $637,000 at September 30, 2006 from $771,000 at December
        31, 2005. The decrease is primarily due to disposition of certain foreclosed
        properties. The Company is actively marketing all of its foreclosed property.
        All foreclosed assets are recorded at the lower of cost or fair value.
        Foreclosed property as of September 30, 2006 excludes $776,000 related to
        two
        branch locations that are held for sale and are reported as other real estate
        owned pursuant to bank regulations and are also recorded at the lower of
        cost or
        fair value.
 
 ***Liquidity
        and Capital Resources***
 
 The
        Company’s liquidity management involves planning to meet the Company’s
        anticipated funding needs at a reasonable cost. Liquidity management is guided
        by policies formulated by the Company’s senior management and the
        Asset/Liability Management Committee of the Company’s Board of Directors. The
        Company had $72.1 million in its most liquid assets, cash and cash equivalents,
        as of September 30, 2006. The Company’s principal sources of funds are loan
        repayments, deposits, Federal Home Loan Bank borrowings and capital and,
        to a
        lesser extent, investment repayments. Core deposits (total deposits less
        certificates of deposits in the amount of $100,000 or more), one of the most
        stable sources of liquidity, together with equity capital, which totaled
        $977.7
        million and $652.1 million at September 30, 2006 and December 31, 2005,
        respectively, funded 69.9% of total assets at September 30, 2006 compared
        to
        67.7% at December 31, 2005. In addition, the Company has the ability to take
        advantage of various other funding programs available from the Federal Home
        Loan
        Bank of Atlanta, as well as access to funding through various brokered deposit
        programs, federal funds lines and security repurchase agreements.
 
 The
        management of equity is a critical aspect of capital management in any business.
        The determination of the appropriate amount of equity is affected by a wide
        number of factors. The primary factor for a regulated financial institution
        is
        the amount of capital needed to meet regulatory requirements, although other
        factors, such as the “risk equity” the business requires and balance sheet
        leverage, also affect the determination.
  On
        February 27, 2006, the Company announced that the Company’s Board of Directors
        had authorized the Company to acquire in the open market or in any private
        transaction, from time-to-time and in accordance with applicable laws, rules
        and
        regulations, up to 1.0 million shares of the Company’s common stock. Management
        plans to utilize share repurchases to manage capital levels of the Company.
        The
        Company plans to effect the repurchase program through open-market purchases.
        During the first n ine
        months of 2006, the Company repurchased 309,721 shares at a weighted average
        price of $16.27 per share. See Part II - Other Information, Item 2. Unregistered
        Sales of Equity Securities and Use of Proceeds for more information on the
        Company’s share repurchases.
 
  -
            23
            -
  To
        be categorized as well capitalized, the Company and the Bank must maintain
        minimum amounts and ratios. The Company’s and the Bank’s actual capital amounts
        and ratios as of September 30, 2006 and the minimum requirements are presented
        in the following table:
 
 Actual
              
              Minimum
                  Requirements
                To
                  Be Well CapitalizedAmount
              
              Ratio
              
              Amount
              
              Ratio*(Dollars
                  in thousands)***Capital
                  Bank Corporation**Total
                  capital (to risk weighted assets)
              
              $
              137,853
              
              
              11.74
              %
              $
              117,409
              
              
              10.00
              %Tier
                  I capital (to risk weighted assets)
              
              
              123,586
              
              
              10.53
              %
              
              70,445
              
              
              6.00
              %Tier
                  1 capital (to average assets)
              
              
              123,586
              
              
              9.53
              %
              
              64,836
              
              
              5.00
              %**Capital
                  Bank**Total
                  capital (to risk weighted assets)
              
              $
              130,562
              
              
              11.18
              %
              $
              116,830
              
              
              10.00
              %Tier
                  I capital (to risk weighted assets)
              
              
              116,295
              
              
              9.95
              %
              
              70,098
              
              
              6.00
              %Tier
                  1 capital (to average assets)
              
              
              116,295
              
              
              9.00
              %
              
              64,584
              
              
              5.00
              %
 
 Consolidated
        capital ratios decreased from December 31, 2005 due to the increase in
        risk-weighted and total assets associated with the 1st State Bancorp transaction
        exceeding the tangible capital acquired. Total capital to risk weighted assets,
        Tier I capital to risk weighted assets and Tier I capital to average assets
        on a
        consolidated basis as of December 31, 2005 were 13.71%, 11.73% and 10.64%,
        respectively.
 
 Shareholders’
        equity was $160.9 million, or $13.98 per share, at September 30, 2006.
        Management believes this level of shareholders’ equity provides adequate capital
        to support the Company’s growth and to maintain a well capitalized
        position.
 
 
 **Item
        3.**  **Quantitative
        and Qualitative Disclosures About Market Risk**
 
 As
        described in more detail in our Annual Report on Form 10-K for the year ended
        December 31, 2005, as amended, asset/liability management involves the
        evaluation, monitoring and management of interest rate risk, liquidity and
        funding. While the Board of Directors has overall responsibility for the
        Company’s asset/liability management policies, the Asset and Liability Committee
        monitors loan, investment, and liability portfolios to ensure comprehensive
        management of interest rate risk and adherence to the policies.
 
 The
        Company utilizes an outside asset/liability management advisory firm to help
        management evaluate interest rate risk and develop asset/liability management
        strategies. One tool used is a computer simulation model which projects the
        Company’s performance under different interest rate scenarios. Analyses are
        prepared quarterly which evaluate the Company’s performance under different
        interest rate scenarios (flat, rising and declining). The following tables
        illustrate the output from the Company’s simulation model based on the balance
        sheets as of September 30, 2006 and December 31, 2005. The tables reflect
        rate-sensitive positions at September 30, 2006 and December 31, 2005, and
        are
        not necessarily indicative of positions on other dates. The projected results
        as
        of September 30, 2006 include the impact of the 1st State Bancorp transaction,
        which was completed on January 3, 2006.
 
 The
        following table illustrates the Company’s interest rate sensitivity as of
        September 30, 2006 and December 31, 2005. The carrying amounts of interest
        rate
        sensitive assets and liabilities are presented in periods in which they next
        reprice to market rates or mature and are aggregated to show the interest
        rate
        sensitivity gap. To reflect anticipated prepayments, certain asset and liability
        amounts were based on estimated cash flows rather than contractual cash flows.
        The Company continues to be “asset sensitive” at September 30, 2006 as its
        assets reprice faster than its liabilities.
  -
            24
            -
  Within
                    One Year
                
                One-Two
                    Years
                
                Two-Five
                    Years
                
                After
                    Five Years
                
                Total*(Dollars
                    in thousands)***As
                    of September 30, 2006**Total
                    assets
                
                $
                838,399
                
                $
                94,444
                
                $
                197,638
                
                $
                269,192
                
                $
                1,399,673Total
                    liabilities and equity
                
                
                752,139
                
                
                219,384
                
                
                176,387
                
                
                251,763
                
                
                1,399,673Interest
                    rate sensitivity gap
                
                $
                86,260
                
                $
                (124,940
                )
                $
                21,251
                
                $
                17,429
                
                $
                -Cumulative
                    interest rate sensitivity gap
                
                $
                86,260
                
                $
                (38,680
                )
                $
                (17,429
                )
                $
                -**As
                    of December 31, 2005**Total
                    assets
                
                $
                569,081
                
                $
                60,830
                
                $
                182,755
                
                $
                148,240
                
                $
                960,906Total
                    liabilities and equity
                
                
                387,158
                
                
                250,575
                
                
                115,821
                
                
                207,352
                
                
                960,906Interest
                    rate sensitivity gap
                
                $
                181,923
                
                $
                (189,745
                )
                $
                66,934
                
                $
                (59,112
                )
                $
                -Cumulative
                    interest rate sensitivity gap
                
                $
                181,923
                
                $
                (7,822
                )
                $
                59,112
                
                $
                -
 As
          of September 30, 2006 and December 31, 2005, under the flat rate scenario,
          the
          Company’s projected net interest income for the next twelve months was $50.8
          million and $34.9 million, respectively. The table below measures the impact
          on
          net interest income of both a gradual and immediate 200 basis point change
          in
          interest rates over the twelve months following the interest rate change.
          Actual
          results could differ from these estimates.
 Change
                    in 12-Months Projected Net Interest Income versus Projected
                  Net
                    Interest Income under No Rate ChangeSeptember
                    30, 2006
                
                December
                    31, 2005Dollar
                    Change
                
                Percent
                    Change
                
                Dollar
                    Change
                
                Percent
                    Change*(Dollars
                    in millions)*Basis
                    point change:+
                    200 gradual
                
                $
                4.1
                
                
                8.1
                %
                $
                2.9
                
                
                8.3
                %+
                    200 immediate
                
                
                5.6
                
                
                11.0
                %
                
                5.2
                
                
                14.9
                %No
                    rate change-
                    200 gradual
                
                
                (1.4
                )
                
                (2.8
                %)
                
                (1.7
                )
                
                (4.9
                %)-
                    200 immediate
                
                
                (2.0
                )
                
                (3.9
                %)
                
                (3.3
                )
                
                (9.5
                %)
 
 The
          table does not reflect the impact of hedging strategies discussed in the
          Company’s Annual Report on Form 10-K for the year ended December 31, 2005, as
          amended, or the $100 million (notional) interest rate swap entered into
          in
          October 2006.
 **Item
        4.**  **Controls
        and Procedures**
 
 The
        Company maintains disclosure controls and procedures that are designed to
        ensure
        that information required to be disclosed in the reports it files or submits
        under the Exchange Act is recorded, processed, summarized and reported within
        the time periods specified in the rules and forms of the SEC, and that such
        information is accumulated and communicated to the Company’s management,
        including its Chief Executive Officer (“CEO”) and Chief Financial Officer
        (“CFO”), as appropriate, to allow timely decisions regarding disclosure.
        Management necessarily applied its judgment in assessing the costs and benefits
        of such controls and procedures, which, by their nature, can provide only
        reasonable assurance regarding management’s control objectives.
 
 As
        required by paragraph (b) of Rule 13a-15 under the Exchange Act, an evaluation
        was carried out under the supervision and with the participation of the
        Company’s management, including the CEO and CFO, of the effectiveness of the
        Company’s disclosure controls and procedures as of the end of the period covered
        by this report. Based upon that evaluation, the CEO and CFO concluded that,
        as
        of the period covered by the report, the Company’s disclosure controls and
        procedures are effective in that they provide reasonable assurances that
        the
        information the Company is required to disclose in the reports it files or
        submits under the Exchange Act is recorded, processed, summarized and reported
        within the time periods required by the SEC’s rules and forms.
  -
            25
            -
  ***Changes
        in Internal Control over Financial Reporting***
 
 There
        were no changes in the Company’s internal control over financial reporting (as
        defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred
        during the period covered by this report that have materially affected or
        are
        reasonably likely to materially affect, the Company’s internal control over
        financial reporting. Management has implemented changes in internal control
        over
        financial reporting as a result of remediation of matters identified through
        its
        review of internal control over financial reporting as required under Section
        404 of the Sarbanes Oxley Act; however, it does not believe any of the changes
        implemented were material in nature.
 
 
 
 **PART
        II - OTHER INFORMATION**
 
 **Item
        1.**  **Legal
        Proceedings**
 
 There
        are no material pending legal proceedings to which the Company is a party
        or to
        which any of its property is subject. In addition, the Company is not aware
        of
        any threatened litigation, unasserted claims or assessments that could have
        a
        material adverse effect on the Company’s business, operating results or
        condition.
 
 **Item
        1A.**  **Risk
        Factors**
 
 You
        should consider the following material risk factors carefully before deciding
        to
        invest in the Company’s securities. Additional risks and uncertainties not
        presently known to us, that we may currently deem to be immaterial or that
        are
        similar to those faced by other companies in our industry or business in
        general, such as competitive conditions, may also impact our business
        operations. If any of the events described below occur, the Company’s business,
        financial condition, or results of operations could be materially adversely
        affected. In that event, the trading price of the Company’s common stock may
        decline, in which case the value of your investment may decline as well.
 
 ***Our
        Results Are Impacted by the Economic Conditions of Our Principal Operating
        Regions***
 
 Our
        operations are concentrated throughout Central and Western North Carolina.
        As a
        result of this geographic concentration, our results may correlate to the
        economic conditions in these areas. Deterioration in economic conditions
        in any
        of these market areas, particularly in the industries on which these geographic
        areas depend, may adversely affect the quality of our loan portfolio and
        the
        demand for our products and services, and accordingly, our results of
        operations.
 
 ***We
        Are Exposed to Risks in Connection with the Loans We
        Make***
 
 A
        significant source of risk for us arises from the possibility that losses
        will
        be sustained because borrowers, guarantors and related parties may fail to
        perform in accordance with the terms of their loans. We have underwriting
        and
        credit monitoring procedures and credit policies, including the establishment
        and review of the allowance for loan losses, that we believe are appropriate
        to
        minimize this risk by assessing the likelihood of nonperformance, tracking
        loan
        performance and diversifying our loan portfolio. Such policies and procedures,
        however, may not prevent unexpected losses that could adversely affect our
        results of operations.
 
 ***We
        Compete with Larger Companies for Business***
 
 The
        banking and financial services business in our market areas continues to
        be a
        competitive field and is becoming more competitive as a result of:
 
 l
              Changes
                  in regulations;
 l
              Changes
                  in technology and product delivery systems;
                  and
 l
              The
                  accelerating pace of consolidation among financial services
                  providers.
 
 We
        may not be able to compete effectively in our markets, and our results of
        operations could be adversely affected by the nature or pace of change in
        competition. We compete for loans, deposits and customers with various bank
        and
        nonbank financial services providers, many of which have substantially greater
        resources including higher total assets and capitalization, greater access
        to
        capital markets and a broader offering of financial services.
 
  -
            26
            -
  ***Our
        Trading Volume Has Been Low Compared with Larger
        Banks***
 
 The
        trading volume in the Company’s common stock on the NASDAQ Global Select Market
        has been comparable to other similarly-sized banks. Nevertheless, this trading
        is relatively low when compared with more seasoned companies listed on the
        NASDAQ Global Select Market or other consolidated reporting systems or stock
        exchanges. Thus, the market in the Company’s common stock may be limited in
        scope relative to other companies.
 
 ***We
        Depend Heavily on Our Key Management Personnel***
 
 The
        Company’s success depends in part on its ability to retain key executives and to
        attract and retain additional qualified management personnel who have experience
        both in sophisticated banking matters and in operating a small to mid-size
        bank.
        Competition for such personnel is strong in the banking industry and we may
        not
        be successful in attracting or retaining the personnel we require. We expect
        to
        effectively compete in this area by offering financial packages that include
        incentive-based compensation and the opportunity to join in the rewarding
        work
        of building a growing bank.
 
 ***Technological
        Advances Impact Our Business***
 
 The
        banking industry is undergoing technological changes with frequent introductions
        of new technology-driven products and services. In addition to improving
        customer services, the effective use of technology increases efficiency and
        enables financial institutions to reduce costs. Our future success will depend,
        in part, on our ability to address the needs of our customers by using
        technology to provide products and services that will satisfy customer demands
        for convenience as well as to create additional efficiencies in our operations.
        Many of our competitors have substantially greater resources than we do to
        invest in technological improvements. We may not be able to effectively
        implement new technology-driven products and services or successfully market
        such products and services to our customers.
 
 ***Government
        Regulations May Prevent or Impair Our Ability To Pay Dividends, Engage in
        Acquisitions or Operate in Other Ways***
 
 Current
        and future legislation and the policies established by federal and state
        regulatory authorities will affect our operations. We are subject to supervision
        and periodic examination by the Federal Deposit Insurance Corporation and
        the
        North Carolina State Banking Commission. Banking regulations, designed primarily
        for the protection of depositors, may limit our growth and the return to
        you,
        our investors, by restricting certain of our activities, such as:
 
 l
              The
                  payment of dividends to our
                  shareholders;
 l
              Possible
                  mergers with or acquisitions of or by other
                  institutions;
 l
              Our
                  desired investments;
 l
              Loans
                  and interest rates on loans;
 l
              Interest
                  rates paid on our deposits;
 l
              The
                  possible expansion of our branch offices;
                  and/or
 l
              Our
                  ability to provide securities or trust
                  services.
 
 We
        also are subject to capitalization guidelines set forth in federal legislation,
        and could be subject to enforcement actions to the extent that we are found
        by
        regulatory examiners to be undercapitalized. We cannot predict what changes,
        if
        any, will be made to existing federal and state legislation and regulations
        or
        the effect that such changes may have on our future business and earnings
        prospects. The cost of compliance with regulatory requirements including
        those
        imposed by the Securities and Exchange Commission may adversely affect our
        ability to operate profitably.
 
 ***There
        Are Potential Risks Associated with Future Acquisitions and
        Expansions***
 
 We
        intend to continue to explore expanding our branch system through selective
        acquisitions of existing banks or bank branches in the Research Triangle
        area
        and other North Carolina markets. We cannot say with any certainty that we
        will
        be able to consummate, or if consummated, successfully integrate, future
        acquisitions, or that we will not incur disruptions or unexpected expenses
        in
        integrating such acquisitions. In the ordinary course of business, we evaluate
        potential acquisitions that would bolster our ability to cater to the small
        business, individual and residential lending markets in North Carolina. In
        attempting to make such acquisitions, we anticipate competing with other
        financial institutions, many of which have greater financial and operational
        resources. In addition, since the consideration for an acquired bank or branch
        may involve cash, notes or the issuance of shares of common stock, existing
        shareholders could experience dilution in the value of their shares of our
        common stock in connection with such acquisitions. Any given acquisition,
        if and
        when consummated, may adversely affect our results of operations or overall
        financial condition.
 
  -
            27
            -
  In
        addition, we may expand our branch network through de novo branches in existing
        or new markets. These de novo branches will have expenses in excess of revenues
        for varying periods after opening, which could decrease our reported
        earnings.
 
 ***Compliance
        with Changing Regulation of Corporate Governance and Public Disclosure May
        Result in Additional Risks and Expenses***
 
 Changing
        laws, regulations and standards relating to corporate governance and public
        disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC regulations,
        are creating uncertainty for companies such as ours. These laws, regulations
        and
        standards are subject to varying interpretations in many cases, and as a
        result,
        their application in practice may evolve over time as new guidance is provided
        by regulatory and governing bodies, which could result in continuing uncertainty
        regarding compliance matters and higher costs necessitated by ongoing revisions
        to disclosure and governance practices. We are committed to maintaining high
        standards of corporate governance and public disclosure. As a result, our
        efforts to comply with evolving laws, regulations and standards have resulted
        in, and are likely to continue to result in, increased expenses and a diversion
        of management time and attention. In particular, our efforts to comply with
        Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations
        regarding management’s required assessment of our internal control over
        financial reporting and our external independent registered public accounting
        firm's audit
        of that assessment has required the commitment of significant financial and
        managerial resources. We expect these efforts to require the continued
        commitment of significant resources. Further, the members of our Board of
        Directors, members of the Audit or Compensation/Human Resources committees,
        our
        chief executive officer, our chief financial officer and certain other of
        our
        executive officers could face an increased risk of personal liability in
        connection with the performance of their duties. As a result, our ability
        to
        attract and retain executive officers and qualified Board and committee members
        could be more difficult. In addition, it may become more difficult and more
        expensive to obtain director and officer liability insurance.
 
 **Item
        2.**  **Unregistered
        Sales of Equity Securities and Use of Proceeds**
 
 The
        following table lists all repurchases (both open market and private
        transactions) during the three months ended September 30, 2006 of any
        of the Company’s securities registered under Section 12 of the Exchange
        Act, by or on behalf of the Company, or any affiliated purchaser of the
        Company:
 
 **Issuer
        Purchase of Equity Securities**
 Month
              
              Total
                  Number of Shares Purchased
              
              Average
                  Price Paid per Share
              
              Total
                  Number of Shares Purchased as Part of Publicly Announced
                  Plans
                or
                  Programs1
              
              Maximum
                  Number of Shares that May Yet Be Purchased Under
                  the Plans or ProgramsJuly
                  2006
              
              
              -
              
              $
              -
              
              
              -
              
              
              782,218August
                  2006
              
              
              30,200
              
              $
              16.98
              
              
              30,200
              
              
              752,018September
                  2006
              
              
              61,739
              
              $
              16.67
              
              
              61,739
              
              
              690,279
 
 1  On
        February 27, 2006, the Company announced that on February 23, 2006 the Company’s
        Board of Directors had authorized a program to repurchase (in the open market
        or
        in any private transaction), up to 1.0 million shares of the Company’s
        outstanding common stock. The repurchase program is for a period of up to
        two
        years and supercedes the share repurchase program authorized by the Company’s
        Board of Directors on December 22, 2004, which authorized the repurchase
        of up
        to 100,000 shares. The Company did not acquire any shares under this former
        repurchase program. As of September 30, 2006, there were an aggregate of 690,279 shares remaining authorized for future
        repurchases.
 
 
 **Item
        3.**  **Defaults
        upon Senior Securities**
 
 None
 
 **Item
        4.**  **Submission
        of Matters to a Vote of Security Holders**
 
 None
 
 **Item
        5.**  **Other
        Information**
 
 None
 
  -
            28 -
  **Item
        6.**  **Exhibits**
  **Exhibit
                  No.**
              
              **Description**Exhibit
                  4.1
              
              In
                  accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain
                  instruments respecting long-term debt of the registrant have been
                  omitted
                  but will be furnished to the Commission upon request.Exhibit
                  10.1
              
              Employment
                  Agreement, dated August 2, 2006, between Capital Bank and Mark
                  Redmond
                  (incorporated by reference to Exhibit 10.1 to Capital Bank Corporation’s
                  current report on Form 8-K filed with the Securities and Exchange
                  Commission on August 4, 2006)Exhibit
                  31.1
              
              Certification
                  of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as
                  adopted
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  2002Exhibit
                  31.2
              
              Certification
                  of A. Christine Baker pursuant to Rule 13a-14(a) and 15d-14(a),
                  as adopted
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  2002Exhibit
                  32.1
              
              Certification
                  of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted
                  Pursuant
                  to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit
                  is being
                  furnished pursuant to Section 906 of the Sarbanes- Oxley Act of
                  2002 and
                  shall not, except to the extent required by that act, be deemed
                  to be
                  incorporated by reference into any document or filed herewith for
                  purposes
                  of liability under the Securities Exchange Act of 1934, as amended,
                  or the
                  Securities Act of 1933, as amended, as the case may
                  be.]Exhibit
                  32.2
              
              Certification
                  of A. Christine Baker pursuant to 18 U.S.C. Section 1350, as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This
                  exhibit is
                  being furnished pursuant to Section 906 of the Sarbanes-Oxley Act
                  of 2002
                  and shall not, except to the extent required by that act, be deemed
                  to be
                  incorporated by reference into any document or filed herewith for
                  purposes
                  of liability under the Securities Exchange Act of 1934, as amended,
                  or the
                  Securities Act of 1933, as amended, as the case may
                  be.]
   -
            29 -
  **Signatures**
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the registrant
        has
        duly caused this report to be signed on its behalf by the undersigned, thereunto
        duly authorized, in Raleigh, North Carolina, on the 9 th
        day of November 2006.
  **CAPITAL
                  BANK CORPORATION**By:  /s/*A.
                  Christine Baker*A.
                  Christine BakerChief
                  Financial Officer(Authorized
                  Officer and Principal Financial
                  Officer)
 
   -
            30 -
  **EXHIBIT
        INDEX**
  **Exhibit
                  No.**
              
              **Description**Exhibit
                  4.1
              
              In
                  accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain
                  instruments respecting long-term debt of the registrant have been
                  omitted
                  but will be furnished to the Commission upon request.Exhibit
                  10.1
              
              Employment
                  Agreement, dated August 2, 2006, between Capital Bank and Mark
                  Redmond
                  (incorporated by reference to Exhibit 10.1 to Capital Bank Corporation’s
                  current report on Form 8-K filed with the Securities and Exchange
                  Commission on August 4, 2006)Exhibit
                  31.1
              
              Certification
                  of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as
                  adopted
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  2002Exhibit
                  31.2
              
              Certification
                  of A. Christine Baker pursuant to Rule 13a-14(a) and 15d-14(a),
                  as adopted
                  pursuant to Section 302 of the Sarbanes-Oxley Act of
                  2002Exhibit
                  32.1
              
              Certification
                  of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted
                  Pursuant
                  to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit
                  is being
                  furnished pursuant to Section 906 of the Sarbanes- Oxley Act of
                  2002 and
                  shall not, except to the extent required by that act, be deemed
                  to be
                  incorporated by reference into any document or filed herewith for
                  purposes
                  of liability under the Securities Exchange Act of 1934, as amended,
                  or the
                  Securities Act of 1933, as amended, as the case may
                  be.]Exhibit
                  32.2
              
              Certification
                  of A. Christine Baker pursuant to 18 U.S.C. Section 1350, as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This
                  exhibit is
                  being furnished pursuant to Section 906 of the Sarbanes-Oxley Act
                  of 2002
                  and shall not, except to the extent required by that act, be deemed
                  to be
                  incorporated by reference into any document or filed herewith for
                  purposes
                  of liability under the Securities Exchange Act of 1934, as amended,
                  or the
                  Securities Act of 1933, as amended, as the case may
                  be.]
 
  -
            31 -