##### Table of Contents

Exhibit 13

















LOGO







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2006



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Annual Report to Shareholders



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##### Table of Contents

Cape Fear Bank Corporation



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TABLE OF CONTENTS



|                                                        |  |         
|------------------------------------------------------- |  | --------
|                                                        |  | Page No.
|Report of Management                                    |  | 3       
|Selected Financial Information and Other Data           |  | 5       
|Quarterly Financial Data                                |  | 7       
|Managements Discussion and Analysis                    |  | 8       
|Report of Independent Registered Public Accounting Firm |  | 21      
|Consolidated Financial Statements                       |  |         
|Balance Sheets                                          |  | 22      
|Statements of Operations                                |  | 23      
|Statements of Comprehensive Income                      |  | 24      
|Statements of Changes in Shareholders Equity           |  | 25      
|Statements of Cash Flows                                |  | 26      
|Notes to Consolidated Financial Statements              |  | 27      
|Management and Bank Personnel                           |  | 49      
|General Corporate Information                           |  | 50      



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Cape Fear Bank Corporation

Report of Management



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Dear Cape Fear Bank Corporation Shareholders:



I am pleased to report that Cape Fear Bank Corporation experienced another year of solid performance, driven by double-digit loan and deposit growth. We
earned $2.3 million this year, or $0.61 per diluted share, up 35.1 percent and 32.6 percent, respectively, from 2005 levels. Our name change came about at the right timeand for all the right reasons: clarity of purpose and a focus more aligned
with the markets now served. While we operate with a new name, our legacy of delivering customer first banking continues today through the dedicated efforts of all Cape Fear Bank associates. We feel uniquely privileged. Our company is built on the
rock-solid foundation of proven experience and the respect of Bank of Wilmingtons name. While our name has changed, much remains the same: we know our business, we know our markets, we know how to manage growth, we know our customersand
they know us.



Today, we are an even stronger, more responsive
and more flexible organization, which will be better positionedcompetitively and organizationallyin order to meet our customers needs. Cape Fear Banks success rests with strong leaders and performers in every corner of our
business. Our talented team is deep in experienceand brimming with enthusiasm and ingenuity. Our associates bring a wealth of experience, values and vision to their roles. To a person, they are committeddeeplyto serving our
customers and advancing our banks mission.



Total earning
assets increased 22.1 percent, an increase of $73.9 million above the prior year, reaching $408.0 million at December 31, 2006. For the same twelve-month period, gross loans grew $56.0 million or 20.1 percent, while deposits increased $69.5 million
or 24.5 percent. A more detailed discussion of what we have achieved and our plan for 2007 and beyond is provided on the following pages.



The past year proved to be a period of sustained improvement and opportunity at our bank. In April, we opened our Waterford office in Leland, our gateway
into Brunswick County. And in October, we opened our permanent office in Surf City, our second location in Pender County. The performance of both offices has been outstanding and we are delighted that these communities have embraced our customer
first banking philosophy. In November, we transitioned to All Day Banking giving our customers flexibility beyond the traditional two oclock banking day turnover. Our customers now receive same day credit on all
deposits made before five oclock.



We are equally excited
about complementing our two existing offices in Wilmington with a third located along Oleander Drive that will open in late spring. Our Sunset Beach office will enlarge our presence in fast growing Brunswick County and will benefit from a
quick start in the second quarter of this year with a seasoned team of local professionals. Their combined skills, understanding of the market and dedication to quality customer satisfaction should yield positive results.



As we continue to expand within our region, we are prompted to consider other
services that we feel support our mission as a full service community bank. After considerable research, we concluded that investor services was a meaningful next step in serving our customer base. As a result, we partnered with Market Street
Advisors, LLC earlier this year. Both of our organizations have a common commitment to high quality customer service and unyielding integrity. To strengthen this arrangement, Market Street Advisors will maintain an office in our Main office.
However, their representatives will be available to meet our clients in any of our branch locations. Both companies are committed to recognizing each other as valuable resources for our customers and we look forward to the rewards of this new
association.



Each of these initiatives underscores our
faithfulness to our disciplined growth strategy and each thoughtful step has been undertaken in the interest of creating greater shareholder value.



Larry W. Flowers has been our Chief Credit Officer and a member of our management team since our organization in 1998. After thoughtful consideration,
Larry has elected to retire from his position effective February 28, 2007. While Larry will slow his day to day responsibilities, I am pleased that he will remain committed to our bank on a part time basis as a Senior Management Advisor. We are
extremely fortunate to have been the beneficiaries of his counsel and leadership. He has been a tremendous source of advice and wisdom to me personally, and to the company. Larrys influence has been immeasurable, his leadership has been
magnificent and his management has been critically effective. He has seen us through unimaginable growth. We will strive to ensure that his retirement does not slow our momentum and that the standards he has set will remain our top priority.



3



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I am pleased that A. Mark Tyler has been named Chief Banking Officer and R. James MacLaren has been named
Chief Credit Officer and that both have joined our management team. Mark and James are incredibly gifted with strong backgrounds in their respective fields. The strength of their character and their professional acumen will serve our shareholders
and our associates well.



I am continually grateful to my
associates. Without their remarkable expertise and dedication, the quality of our customers experiences would fall far short of our standards and expectations. Our financial and operational performance will be matched, always, by an abiding
commitment to integrity and stewardshipand to making the communities we serve better for our presence.



Before you turn the page, on behalf of the associates of Cape Fear Bank who work hard on your behalf every day, I would like to thank you personally for
your continued support. We are in the midst of an exciting and dynamic time, and we are honored that you have chosen to grow with us.



Best regards,



LOGO

Cameron Coburn

Chairman, President
and CEO



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Cape Fear Bank Corporation and Subsidiary

Selected Financial Information and Other Data



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|                                                      |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|----------------------------------------------------- |  | ------------------------------------------------------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | --------- | - |  | - | --------- | -
|                                                      |  | At or for the Years Ended December 31,                  |          
|                                                      |  | 2006                                                    |           |   | 2005 |   |           | 2004 |  |   | 2003      |   |  | 2002 |          
|                                                      |  | (Dollars in thousands, except share and per share data) |          
|Income Statement Data:                                |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Interest income                                       |  | $                                                       | 28,196    |   |      | $ | 16,412    |      |  | $ | 8,596     |   |  | $    | 6,527     |   |  | $ | 6,747     |  
|Interest expense                                      |  |                                                         | 15,302    |   |      |   | 7,113     |      |  |   | 2,742     |   |  |      | 2,103     |   |  |   | 2,927     |  
|                                                      |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net interest income                                   |  |                                                         | 12,894    |   |      |   | 9,299     |      |  |   | 5,854     |   |  |      | 4,424     |   |  |   | 3,820     |  
|Provision for loan losses                             |  |                                                         | 1,340     |   |      |   | 1,499     |      |  |   | 892       |   |  |      | 291       |   |  |   | 575       |  
|Noninterest income                                    |  |                                                         | 1,093     |   |      |   | 1,048     |      |  |   | 746       |   |  |      | 512       |   |  |   | 447       |  
|Noninterest expense                                   |  |                                                         | 9,324     |   |      |   | 6,381     |      |  |   | 4,626     |   |  |      | 3,628     |   |  |   | 3,055     |  
|Provision for income taxes                            |  |                                                         | 1,051     |   |      |   | 785       |      |  |   | (66       | ) |  |      |          |   |  |   |          |  
|                                                      |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net income                                            |  | $                                                       | 2,272     |   |      | $ | 1,682     |      |  | $ | 1,148     |   |  | $    | 1,017     |   |  | $ | 637       |  
|                                                      |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Per share data and shares outstanding: (1)            |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Basic net income per share                            |  | $                                                       | 0.63      |   |      | $ | 0.47      |      |  | $ | 0.39      |   |  | $    | 0.52      |   |  | $ | 0.36      |  
|Diluted net income per share                          |  |                                                         | 0.61      |   |      |   | 0.46      |      |  |   | 0.38      |   |  |      | 0.51      |   |  |   | 0.36      |  
|Book value at period end                              |  |                                                         | 7.54      |   |      |   | 6.87      |      |  |   | 6.53      |   |  |      | 5.88      |   |  |   | 4.81      |  
|Weighted average number of common shares outstanding: |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Basic                                                 |  |                                                         | 3,586,641 |   |      |   | 3,586,361 |      |  |   | 2,906,442 |   |  |      | 1,949,596 |   |  |   | 1,754,044 |  
|Diluted                                               |  |                                                         | 3,709,236 |   |      |   | 3,671,619 |      |  |   | 2,982,550 |   |  |      | 1,992,181 |   |  |   | 1,768,487 |  
|Shares outstanding at period end                      |  |                                                         | 3,586,780 |   |      |   | 3,586,518 |      |  |   | 3,575,442 |   |  |      | 2,841,729 |   |  |   | 1,785,009 |  
|                                                      |  |                                                         |           |   |     
|Balance sheet data:                                   |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total assets                                          |  | $                                                       | 424,885   |   |      | $ | 343,327   |      |  | $ | 201,533   |   |  | $    | 129,785   |   |  | $ | 112,762   |  
|Loans receivable                                      |  |                                                         | 334,409   |   |      |   | 278,386   |      |  |   | 162,399   |   |  |      | 104,042   |   |  |   | 87,741    |  
|Allowance for loan losses                             |  |                                                         | 4,536     |   |      |   | 3,510     |      |  |   | 2,106     |   |  |      | 1,661     |   |  |   | 1,481     |  
|Other interest-earning assets                         |  |                                                         | 73,583    |   |      |   | 55,667    |      |  |   | 31,251    |   |  |      | 24,171    |   |  |   | 22,605    |  
|Total deposits                                        |  |                                                         | 353,617   |   |      |   | 284,134   |      |  |   | 170,168   |   |  |      | 106,077   |   |  |   | 103,862   |  
|Borrowings                                            |  |                                                         | 41,310    |   |      |   | 32,310    |      |  |   | 7,400     |   |  |      | 6,500     |   |  |   |          |  
|Shareholders equity                                  |  |                                                         | 27,052    |   |      |   | 24,635    |      |  |   | 23,338    |   |  |      | 16,712    |   |  |   | 8,593     |  
|                                                      |  |                                                         |           |   |     
|Selected average balances                             |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Total assets                                          |  |                                                         | 396,272   |   |      |   | 271,258   |      |  |   | 164,220   |   |  |      | 114,488   |   |  |   | 107,490   |  
|Loans, gross                                          |  |                                                         | 311,226   |   |      |   | 217,604   |      |  |   | 130,734   |   |  |      | 92,269    |   |  |   | 86,144    |  
|Total interest-earning assets                         |  |                                                         | 386,323   |   |      |   | 262,669   |      |  |   | 159,404   |   |  |      | 112,590   |   |  |   | 103,792   |  
|Deposits                                              |  |                                                         | 334,373   |   |      |   | 226,823   |      |  |   | 140,356   |   |  |      | 103,847   |   |  |   | 98,492    |  
|Total interest-bearing liabilities                    |  |                                                         | 337,004   |   |      |   | 222,138   |      |  |   | 132,166   |   |  |      | 95,995    |   |  |   | 91,498    |  
|Shareholders equity                                  |  |                                                         | 25,643    |   |      |   | 24,167    |      |  |   | 17,803    |   |  |      | 9,801     |   |  |   | 8,171     |  
|                                                      |  |                                                         |           |   |     
|Selected performance ratios:                          |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Return on average assets                              |  |                                                         | 0.57      | % |      |   | 0.62      | %    |  |   | 0.70      | % |  |      | 0.89      | % |  |   | 0.59      | %
|Return on average shareholders equity                |  |                                                         | 8.86      | % |      |   | 6.96      | %    |  |   | 6.45      | % |  |      | 10.38     | % |  |   | 7.80      | %
|Net interest margin(2)                                |  |                                                         | 3.34      | % |      |   | 3.54      | %    |  |   | 3.67      | % |  |      | 3.93      | % |  |   | 3.68      | %
|Net interest spread(3)                                |  |                                                         | 2.76      | % |      |   | 3.05      | %    |  |   | 3.32      | % |  |      | 3.61      | % |  |   | 3.30      | %
|Efficiency ratio(4)                                   |  |                                                         | 66.66     | % |      |   | 61.67     | %    |  |   | 70.09     | % |  |      | 73.50     | % |  |   | 71.60     | %
|                                                      |  |                                                         |           |   |     
|Asset quality ratios (at period end):                 |  |                                                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Nonperforming loans to period-end loans               |  |                                                         | 0.10      | % |      |   | 0.42      | %    |  |   | 0.61      | % |  |      | 0.83      | % |  |   | 0.73      | %
|Allowance for loan losses to period-end loans         |  |                                                         | 1.36      | % |      |   | 1.26      | %    |  |   | 1.30      | % |  |      | 1.60      | % |  |   | 1.69      | %
|Allowance for loan losses to nonperforming loans      |  |                                                         | 1,296.00  | % |      |   | 298.98    | %    |  |   | 212.02    | % |  |      | 191.80    | % |  |   | 230.69    | %
|Nonperforming assets to total assets(5)               |  |                                                         | 0.23      | % |      |   | 0.34      | %    |  |   | 0.59      | % |  |      | 0.67      | % |  |   | 0.70      | %
|Net loan chage-offs to average loans outstanding      |  |                                                         | 0.10      | % |      |   | 0.04      | %    |  |   | 0.34      | % |  |      | 0.12      | % |  |   | 0.30      | %



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|                              |  |                                                         |   |  |       |   |  |       |   |  |       |   |  |       |  
|----------------------------- |  | ------------------------------------------------------- | - |  | ----- | - |  | ----- | - |  | ----- | - |  | ----- | -
|                              |  | At or for the Years Ended December 31,                  |  
|                              |  | 2006                                                    |   |  | 2005  |   |  | 2004  |   |  | 2003  |   |  | 2002  |  
|                              |  | (Dollars in thousands, except share and per share data) |  
|Capital and liquidity ratios: |  |                                                         |   |  |       |   |  |       |   |  |       |   |  |       |  
|Total Capital Ratio           |  | 11.80                                                   | % |  | 13.29 | % |  | 14.87 | % |  | 16.98 | % |  | 10.74 | %
|Tier 1 Capital Ratio          |  | 10.12                                                   | % |  | 12.09 | % |  | 13.64 | % |  | 15.73 | % |  | 9.48  | %
|Leverage Capital Ratio        |  | 9.22                                                    | % |  | 10.69 | % |  | 12.29 | % |  | 13.92 | % |  | 7.70  | %
|Equity to assets ratio        |  | 6.37                                                    | % |  | 7.18  | % |  | 11.57 | % |  | 12.88 | % |  | 7.62  | %
|                              |  |                                                         |   |  |      
|Other Data:                   |  |                                                         |   |  |       |   |  |       |   |  |       |   |  |       |  
|Full service branch offices   |  | 5                                                       |   |  | 3     |   |  | 3     |   |  | 2     |   |  | 2     |  
|Loan production offices       |  |                                                        |   |  |      |   |  |      |   |  | 1     |   |  |      |  
|Full-time employees           |  | 90                                                      |   |  | 62    |   |  | 50    |   |  | 36    |   |  | 30    |  

---

|(1) |  | Computed based on the weighted average number of shares outstanding during each period. Basic and
diluted net income per share has been computed based on the weighted average number of shares outstanding during each period after retroactively adjusting for a 5% stock dividend on June 30, 2006.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Net interest margin is net
interest income divided by average interest-earning assets.
|--- |  | --------------------------------------------------------------------------------------

|(3) |  | Net interest spread is the
difference between the average yield on interest-earning assets and the average cost of interest bearing liabilities.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | Efficiency ratio is noninterest
expense divided by the sum of net interest income and noninterest income.
|--- |  | ---------------------------------------------------------------------------------------------------------

|(5) |  | Nonperforming assets consist of
non-accruing loans, restructured loans and foreclosed assets, where applicable.
|--- |  | ---------------------------------------------------------------------------------------------------------------



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Cape Fear Bank Corporation and Subsidiary

Quarterly Financial Data



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|                                    |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|----------------------------------- |  | ------------------------------------- | ----- | ---------------------------- | - | ------------- |  | ------------ | ----- | ------------- | - | ------------ |  | ------------- | ----- | ------------ | - | ----- |  | - | ----- |  | - | -----
|                                    |  | Year Ended December 31, 2006          |       | Year Ended December 31, 2005
|                                    |  | FourthQuarter                         |       | ThirdQuarter                 |   | SecondQuarter |  | FirstQuarter |       | FourthQuarter |   | ThirdQuarter |  | SecondQuarter |       | FirstQuarter
|                                    |  | (In thousands, except per share data)
|Operating Data:                     |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Total interest income               |  | $                                     | 7,796 |                              | $ | 7,477         |  | $            | 6,757 |               | $ | 6,166        |  | $             | 5,363 |              | $ | 4,418 |  | $ | 3,676 |  | $ | 2,955
|Total interest expense              |  |                                       | 4,509 |                              |   | 4,126         |  |              | 3,587 |               |   | 3,079        |  |               | 2,566 |              |   | 1,949 |  |   | 1,496 |  |   | 1,102
|                                    |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Net interest income                 |  |                                       | 3,287 |                              |   | 3,351         |  |              | 3,170 |               |   | 3,087        |  |               | 2,797 |              |   | 2,469 |  |   | 2,180 |  |   | 1,853
|Provision for loan losses           |  |                                       | 220   |                              |   | 436           |  |              | 391   |               |   | 293          |  |               | 388   |              |   | 355   |  |   | 392   |  |   | 365  
|                                    |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Net interest income after provision |  |                                       | 3,067 |                              |   | 2,915         |  |              | 2,779 |               |   | 2,794        |  |               | 2,409 |              |   | 2,114 |  |   | 1,788 |  |   | 1,488
|Noninterest income                  |  |                                       | 248   |                              |   | 267           |  |              | 337   |               |   | 240          |  |               | 292   |              |   | 264   |  |   | 246   |  |   | 248  
|Noninterest expense                 |  |                                       | 2,577 |                              |   | 2,393         |  |              | 2,280 |               |   | 2,074        |  |               | 1,794 |              |   | 1,735 |  |   | 1,459 |  |   | 1,393
|                                    |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Income before income taxes          |  |                                       | 738   |                              |   | 789           |  |              | 836   |               |   | 960          |  |               | 907   |              |   | 643   |  |   | 575   |  |   | 343  
|Provision for income taxes          |  |                                       | 150   |                              |   | 231           |  |              | 314   |               |   | 356          |  |               | 270   |              |   | 221   |  |   | 192   |  |   | 102  
|                                    |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Net income                          |  | $                                     | 588   |                              | $ | 558           |  | $            | 522   |               | $ | 604          |  | $             | 637   |              | $ | 422   |  | $ | 383   |  | $ | 241  
|                                    |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Per Share Data:                     |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|Earnings per share-basic            |  | $                                     | 0.16  |                              | $ | 0.16          |  | $            | 0.15  |               | $ | 0.17         |  | $             | 0.18  |              | $ | 0.12  |  | $ | 0.11  |  | $ | 0.07 
|Earnings per share-diluted          |  |                                       | 0.16  |                              |   | 0.15          |  |              | 0.14  |               |   | 0.16         |  |               | 0.17  |              |   | 0.11  |  |   | 0.10  |  |   | 0.07 
|Common stock price:                 |  |                                       |       |                              |   |               |  |              |       |               |   |              |  |               |       |              |   |       |  |   |       |  |   |      
|High                                |  | $                                     | 12.85 |                              | $ | 12.99         |  | $            | 13.05 |               | $ | 11.70        |  | $             | 10.33 |              | $ | 10.43 |  | $ | 10.22 |  | $ | 9.01 
|Low                                 |  |                                       | 11.10 |                              |   | 12.10         |  |              | 11.33 |               |   | 10.19        |  |               | 9.52  |              |   | 9.20  |  |   | 8.00  |  |   | 8.57 



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Cape Fear Bank Corporation and Subsidiary

Managements Discussion and Analysis



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Managements discussion and analysis is intended to assist readers in the understanding and evaluation of the financial condition and consolidated
results of operations of Cape Fear Bank Corporation (the Company). The analysis includes detailed discussions for each of the factors affecting the Companys operating results and financial condition for the years ended
December 31, 2006, 2005, and 2004. It should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this report, the supplemental financial data appearing throughout this discussion and
analysis, and referenced financial data tables included in the Companys 2006 Form 10-K. Because the Company has no operations and conducts no business on its own other than owning Cape Fear Bank (the Bank) and BKWW Statutory Trust
I (the Trust), the discussion contained in this Managements Discussion and Analysis concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated
basis, the Company and its subsidiaries are collectively referred to herein as the Company unless otherwise noted.



DESCRIPTION OF BUSINESS



The Companys headquarters and operations are located in Wilmington, North Carolina and it conducts business primarily in New Hanover, Pender and
Brunswick Counties. Cape Fear Bank Corporation is a North Carolina-chartered bank holding company incorporated on June 20, 2005 for the sole purpose of serving as the parent holding company for Cape Fear Bank, a North Carolina state-chartered
bank that began banking operations on June 22, 1998. On September 1, 2005, Cape Fear Bank Corporation completed a reorganization and share exchange in which Cape Fear Bank became our wholly-owned subsidiary. Upon formation, one share of
the Banks $3.50 par value common stock was exchanged for one newly issued share of the Companys $3.50 par value common stock. In addition, on October 4, 2005, the Company formed a new unconsolidated wholly-owned subsidiary, BKWW
Statutory Trust I, to facilitate the issuance of trust preferred securities. The Company currently has no operations and conducts no business on its own other than owning the Bank and the Trust. The formation of the Company had no impact on the
operations of the Bank. The consolidated capitalization, assets, liabilities, income and expenses of the Company immediately following its formation were substantially the same as those of the Bank immediately prior to the formation.



We engage in a general, community-oriented commercial and consumer banking
business. The primary business of the Company is to solicit deposits and invest those funds by originating loans in its established market area. The Companys lending activities are oriented to the small-to-medium sized business as well as to
the consumer/retail customer located in New Hanover, Pender and Brunswick Counties. The Company offers commercial, consumer, and mortgage lending products. Funds are also invested, to a lesser extent, in investment securities, Federal funds and
interest earning accounts with correspondent banks. The deposit services offered by the Company include small business and personal checking, savings accounts and certificates of deposit. The Company concentrates on customer relationships in
building deposit base. Additional sources of funding available to the Company include borrowings from the Federal Home Loan Bank of Atlanta, Federal funds purchased from correspondent banks and brokered certificates of deposit.



The Company operates four full-service branch locations in addition to its
corporate headquarters and Main Office at 1117 Military Cutoff Road in Wilmington, NC. The other branches are located at 3702 South College Road in Wilmington, NC; Unit 1-A, 14572 US Highway 17 in Hampstead, NC; 13500 Highway 50, Suite 101 in Surf
City, NC; and 503 Olde Waterford Way, Suite 104 in Leland, NC. The Company is also expanding in its New Hanover County market by opening a full-service branch in second quarter 2007 at 4008 Oleander Drive, Wilmington, NC and another full-service
office in the Sunset Beach community in Brunswick County in second quarter 2007 as well.



On December 31, 2006 and 2005, the Company had total consolidated assets of approximately $424.9 million and $343.3 million, respectively; total consolidated loans of approximately $334.4 million and $278.4
million, respectively; total consolidated deposits of approximately $353.6 million and $284.1 million, respectively; and total consolidated shareholders equity of approximately $27.1 million and $24.6 million, respectively. The Companys
deposits are insured under the FDICs Deposit Insurance Fund to the maximum amount permitted by law.



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Business Strategy



The primary elements of the Companys business strategy are described below.



| |  |  | Focus.    We will continue to focus on community banking and to distinguish our bank from our competition through our commitment to
customers and quality service.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Growth.    We believe we will have opportunities to grow as larger financial institutions continue to expand and to de-emphasize community
banking philosophies and customer contact. We will seek to grow in our existing banking market (internally and through additional offices), and to expand into new markets as appropriate opportunities arise.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Profitability.    We believe the cornerstone of community banking is a commitment to service, and that earnings are directly related to our ability
to cross-sell our products and services. We also believe that we must control expenses. We will seek to increase our revenues by promoting relationship banking with our customers and containing our operating expenses.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Employees.    We believe that one of our greatest strengths is our experienced staff which is dedicated to a philosophy of customer service and
community banking. We will seek to retain employees who are motivated and relationship oriented.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



FINANCIAL CONDITION

DECEMBER 31, 2006 and 2005



The Companys growth moderated in 2006 compared with the significant
growth of 2005. The Company ended December 31, 2006 with total assets of $424.9 million, an increase of $81.6 million or 23.8% compared to December 31, 2005 with total assets of $343.3 million, an increase of $141.8 million or 70.4% from
the year ended December 31, 2004. The moderated growth in 2006 is attributed to the economic slow down in real estate markets. Although the national and state real estate markets have slowed dramatically, the coastal real estate markets in
which Cape Fear Bank Corporation operates have experienced a more moderate decline. During 2005, the Company had an aggressive growth plan designed to leverage the $5.5 million in additional capital received from a common stock offering completed in
the fourth quarter of 2004. Loan demand was high in the growing coastal real estate market. Therefore, to take advantage of future growth opportunities, the Company formed a statutory trust that issued $10 million in trust preferred securities in
the fourth quarter of 2005 to obtain additional funds to augment the Banks regulatory capital for even further leverage. The Company implemented its expansion plans with the opening of two new full-service branches, both in April 2006. The
Surf City branch was its second location in Pender County and the Waterford branch was its first venture into the fast growing Brunswick County market. Additional branches are planned during 2007 as well. Total customer deposits increased by $69.5
million or 24.5% during 2006 compared with an increase of $114.0 million or 67.0% during 2005. The deposit growth included $20.3 million and $42.1 million in 2006 and 2005, respectively, in Internet and brokered deposits. The $69.5 million deposit
growth in 2006, combined with net income of $2.3 million and additional borrowings of $9.0 million provided funding for the growth of $20.9 million in investments available for sale and $56.0 million in total loans receivable during the current
year. Total shareholders equity increased by $2.4 million during 2006, principally due to the retention of net income of $2.3 million earned during the year. The Companys regulatory capital was successfully maintained at well
capitalized levels throughout the period.



Total earning
assets increased $73.9 million or 22.1% during the year, increasing from $334.1 million at year end 2005 to $408.0 million at year end 2006. Loans made up the largest percentage of the increase. Gross loans increased by $56.0 million or 20.1%, from
$278.4 million at December 31, 2005 to $334.4 million at December 31, 2006. Construction loans experienced the most significant net growth during the year, increasing $41.1 million or 35.2%, from $116.6 million to $157.7 million. Although
moderated from the previous year growth, the continued increase in construction real estate loans was aided by the population growth in the Companys market area and the efforts of specialized construction lenders on its staff. Net growth in
other loan categories were as follows: commercial mortgage loans increased $6.7 million or 7.7% from $87.3 million to $94.0 million, home equity lines of credit increased $6.4 million or 26.5% from $24.3 million to $30.7 million, residential
mortgage loans increased $2.7 million or 8.3%, from $32.4 million to $35.0 million, commercial and industrial loans remained flat at $14.5 million, and consumer loans decreased $1.1 million or 30.7%, from $3.5 million to $2.4 million.



The composition of the loan portfolio, by category, at December 31, 2006
is as follows: 47.1% construction loans, 28.1% commercial mortgage loans, 10.5% residential mortgages, 9.2% home equity lines of credit, 4.4% commercial and



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industrial, and 0.7% consumer. The composition of the loan portfolio, by category, as of December 31, 2005 was as follows: 41.9% construction loans,
31.3% commercial mortgage loans, 11.6% residential mortgages, 8.7% home equity lines of credit, 5.2% commercial and industrial loans, and 1.3% consumer loans.



The amortized cost of the Companys investment portfolio was $70.1 million and the fair market value was $69.6 million at December 31, 2006.
The amortized cost of the Companys investment portfolio was $49.5 million and the fair market value was $48.7 million at December 31, 2005. All investments are accounted for as available for sale under Financial Accounting Standards Board
(FASB) No. 115 and are presented at their fair market value. The investment portfolio experienced a net increase of $20.9 million or 43.0% in 2006 compared to an increase of $22.2 million or 84.0% in 2005, increasing from $48.7
million at year end 2005 to $69.6 million at year end 2006. The largest category increase in the investment portfolio was in mortgage backed securities, increasing $9.6 million or 38.0%, from $25.1 million to $34.7 million. The Company continued its
investment in municipal bonds to take advantage of the tax-effect yield since becoming fully taxable in 2005. Municipal bonds increased by $7.3 million or 42.7%, growing from $17.1 million to $24.4 million. U.S. agency securities increased $4.0
million or 69.2%, from $5.9 million to $9.9 million at year end 2006. The Companys investment portfolio consisted of U.S. Government agency securities, municipal bonds, collateralized mortgage obligations (CMOs), mortgage-backed securities,
and corporate bonds. The Company also owned $2.1 million of Federal Home Loan Bank stock at December 31, 2006 compared with $1.4 million at December 31, 2005. The Company had $298 thousand in time deposits in other banks and $1.6 million
in funds invested in short-term overnight deposits at Federal Home Loan Bank of Atlanta at December 31, 2006. At year end 2005, there was $5.4 million invested in short-term overnight deposits at Federal Home Loan Bank of Atlanta and $199
thousand in time deposits in other banks.



Non-interest earning
assets total $21.4 million at December 31, 2006 versus $12.8 million at December 31, 2005, increasing by $8.6 million or 67.6%. Premises and equipment totaled approximately $3.0 million at December 31, 2006, reflecting a $1.1 million
net increase over the prior year. The Company opened two full service branches during April 2006, one in Surf City, NC and one in Leland, NC, which accounts for most of the increase. In addition it added a credit administration support facility
located behind its Main Office headquarters during June 2006. The Company has $5.5 million invested in bank owned life insurance at December 31, 2006. This investment increased in cash surrender value by $195 thousand during 2006. Cash and due
from banks increased $5.4 million or 288.8% from $1.9 million to $7.2 million at year end 2006. A portion of the cash increase was $5 million in an overnight transit cash letter that was transferred to an interest-earning account the next day. The
Company also had an Other Real Estate Owned property valued at $616 thousand at year end 2006 versus none at year end 2005. Accrued interest receivable increased by $550 thousand due to the higher volume of earning assets. Other assets increased by
$820 thousand primarily due to an increase in equity investment in the Trust and changes in deferred tax assets.



Total deposits increased by $69.5 million or 24.5%, growing from $284.1 million at December 31, 2005 to $353.6 million at December 31, 2006. The
time deposit growth for 2006 included $20.3 million of Internet and brokered deposits. Time deposits experienced the greatest increase, growing by $47.9 million or 21.8%, from $220.2 million at year end 2005 to $268.1 million at year end 2006.
Savings accounts grew by $8.6 million or 330.0% due to a special rate promotion in the last half of 2006. Increases in other deposit categories included $7.0 million in non-interest bearing demand deposits growing to $33.1 million and $6.0 million
in money market and NOW accounts growing to $41.3 million, which can be attributed to the Companys branching initiatives.



The composition of the deposit base, by category, at December 31, 2006 is as follows: 75.8% in time deposits, 11.7% in money market and NOW accounts,
9.4% in non-interest bearing demand deposits, and 3.1% in savings accounts. The composition of the deposit base, by category, at December 31, 2005 was as follows: 77.5% in time deposits, 12.4% in money market and NOW accounts, 9.2% in
non-interest bearing demand deposits, and 0.9% in savings accounts. At December 31, 2006 the Company had $131.0 million in time deposits of $100 thousand or more compared to $96.0 million at December 31, 2005. Earning assets growth during
2006 required the Company to rely more heavily on retail and brokered time deposits as a source of funds.



Total borrowings increased by $9.0 million, from $32.3 million at December 31, 2005 to $41.3 million at December 31, 2006. Total borrowings at
December 31, 2006 consisted of $3.0 million in short-term and $28.0 million in long-term Federal Home Loan Bank advances in addition to the $10.3 million in junior subordinated debt issued to the Trust in connection with the issuance of trust
preferred securities. At December 31, 2005 total borrowings consisted of $22.0 million in long-term Federal Home Loan Bank advances in addition to the $10.3 million in junior subordinated debt issued to the Trust in connection with the issuance
of trust preferred securities.



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Accrued expenses and other liabilities increased by $658 thousand to $2.9 million at December 31,
2006 compared to $2.2 million at December 31, 2005. Accrued interest payable increased due to the volume of interest-bearing liabilities added during 2006 combined with the effects of rate increases on deposits. Also contributing to the
increase in accrued expenses was approximately $348 thousand of expenses associated with the supplemental retirement plan for certain officers and directors.



Total stockholders equity increased by $2.4 million between December 31, 2005 and December 31, 2006. The increase was principally the result of
net income for 2006 of $2.3 million.



RESULTS OF OPERATIONS
FOR THE YEARS ENDED

DECEMBER 31, 2006, 2005 AND 2004



Overview.    The Company achieved net income of $2.3 million in 2006, an increase of $590
thousand or 35.1% from net income of $1.7 million in 2005. Net income increased $534 thousand or 46.5% in 2005 from net income of $1.1 million in 2004. Net income increased $131 thousand or 12.9% in 2004 from year end 2003. On a per share basis, net
income for 2006 was $0.63 per share basic and $0.61 per share diluted as compared with $0.47 per share basic and $0.46 per share diluted in 2005 and $0.39 per share basic and $0.38 per share diluted in 2004. The earnings per basic and diluted share
were restated for the prior periods for a 5% stock dividend effective June 30, 2006. The improvement in net operating results for 2006 is primarily attributable to a $3.6 million increase in net interest income from 2005 to 2006, achieved
principally as a result of significant growth in interest earning assets over the past year, leveraged with the growth in 2005. Net interest income increased $3.4 million from 2004 to 2005 from the growth in interest earning assets as well. During
2004, net interest income only increased by $1.4 million. The 2006 net interest income increase of $3.6 million, combined with a $45 thousand increase in non-interest income and a $159 thousand reduction in the provision for loan losses, was
tempered by a $2.9 million growth related increase in non-interest expenses. The 2005 increased net interest income of $3.4 million, combined with an increase of $302 thousand in non-interest income, was tempered by an increase of $607 thousand in
loan loss provision and growth related increases of $1.8 million in non-interest expenses. In 2004, the $1.4 million net interest income increase plus the $233 thousand increase in non-interest income was offset by the $601 thousand increase in the
provision for loan losses and the $997 thousand growth related increase in non-interest expenses. The Company recorded a tax provision of $1.1 million in 2006. The Company became fully taxable during 2005, recording an income tax provision of $785
thousand versus an income tax benefit of $66 thousand in 2004. This difference was principally due to adjustments to the valuation allowance associated with deferred tax assets. Return on average assets was 0.57%, 0.62% and 0.70% for the years ended
December 31, 2006, 2005 and 2004, respectively. Return on average equity for the years ended December 31, 2006, 2005, and 2004 was 8.86%, 6.96%, and 6.45%, respectively. Net interest margin pressure and growth related non-interest expenses
along with the 46.1% increase in total average assets in 2006 contributed to the decline in return on average assets. The 65.2% increase in total average assets along with the income tax expense in 2005 contributed to the decline in that year. There
was a tax benefit recorded in 2004. In 2004, there was a 43.4% increase in total average assets.



Net Interest Income.    Like most financial institutions, the primary component of earnings for the Company is net interest
income. Net interest income is the difference between interest income, principally from loan and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from
changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and
the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as
well as by levels of noninterest-bearing liabilities and capital.



Net interest income for 2006 increased to $12.9 million, a $3.6 million or 38.7% increase from the $9.3 million earned in 2005. The 2005 $9.3 million was a $3.4 million or 58.8% increase from the $5.9 million earned in 2004. The significant
growth in average interest-earning assets of $123.7 million from $262.7 million during 2005 to $386.3 million during 2006 was the primary reason for the improvement in the level of net interest income. This was leveraged with the significant growth
in average interest-earning assets of $103.3 million from $159.4 million during 2004 to $262.7 million during 2005 which resulted in the improvement in the level of net interest income in that year as well. Average interest earning assets grew $46.8
million or 41.6% in 2004 resulting in improvement in net interest income. In 2006, the



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Company benefited from the increase in the level of interest-earning assets coupled with the effects of a 105 basis point increase in the average yield on
those assets from 6.25% at the end of 2005 to 7.30% at the end of 2006. In 2005, the Company again benefited from the increase in the level of interest-earning assets coupled with the effects of an 86 basis point increase in the average yield on
those assets from 5.39% at the end of 2004 to 6.25% at the end of 2005. In 2004, the increase in average interest-earning assets offset the 41 basis point decline in the average yield on those assets from 5.80% down to 5.39% at year end 2004. The
Company continued to increase its investment in higher yielding municipal securities during 2006, increasing $7.3 million. In 2005, the Company made a significant increase, $16.7 million, in higher yielding municipal securities in its investment
portfolio with its fully taxable status in 2005 and had a minimal investment of $403 thousand in municipal securities in 2004.



The Companys average interest-bearing liabilities increased by $114.9 million or 51.7% in 2006, $90.0 million, or 68.1% in 2005, and $36.2 million
or 37.7% in 2004, consistent with its increase in interest-earning assets for those years. While the average cost of interest-bearing liabilities increased by 134 basis points from 3.20% to 4.54% in 2006 and 113 basis points from 2.07% to 3.20% in
2005, the impact was mitigated by the volume increase in interest-earning assets. In 2004, the cost of interest-bearing liabilities declined 12 basis points from 2.19% to 2.07%. While net interest income increased significantly from period to
period, the net interest spread and margin both decreased in 2006, 2005, and 2004. For the year ending December 31, 2006, net interest spread was 2.76% and net interest margin was 3.34%. For the year ending December 31, 2005, net interest
spread was 3.05% and net interest margin was 3.54%. For the year ending December 31, 2004, net interest spread was 3.32% and net interest margin was 3.67%. The Companys increased reliance on interest-bearing liabilities to fund earning
assets caused the decline in interest margin and spread in each of the years. The ratio of average interest-earning assets to average interest-bearing liabilities was 114.63%, 118.25%, and 120.61% at December 31, 2006, 2005, and 2004,
respectively.



Total average interest earning assets were
$386.3 million, increasing by $123.7 million or 47.1% in 2006, $262.7 million, increasing by $103.3 million or 64.8% in 2005 and $159.4 million, increasing by $46.8 million or 41.6% in 2004. Average loans outstanding were $311.2 million, increasing
by $93.6 million or 43.0% in 2006, $217.6 million, increasing $86.9 million or 66.4% in 2005, and $130.7 million, increasing $38.5 million or 41.7% in 2004. The average balance of investment securities grew by $24.3 million or 68.7% to $59.6 million
for 2006, $13.6 million or 62.8% to $35.3 million for 2005, and $5.8 million or 36.4% to $21.7 million for 2004. Other average interest earning assets grew to $15.5 million, $9.7 million, and $7.0 million in 2006, 2005, and 2004, respectively. Total
average interest-bearing liabilities increased by $114.9 million in 2006, with interest-bearing deposits increasing $99.2 million or 48.9% and borrowings increasing $15.7 million or 80.6%. In 2005, average interest-bearing liabilities increased
$90.0 million with average interest-bearing deposits increasing by $76.1 million or 60.1% and borrowings increasing by $13.9 million or 251.8%. In 2004, average interest-bearing liabilities increased $36.2 million with average interest-bearing
deposits increasing by $31.1 million or 32.6% and borrowings increasing by $5.0 million or 1,034.9%.



Total interest income increased by $11.8 million, $7.8 million, and $2.1 million for 2006, 2005, and 2004, respectively. The total interest income
increase for 2006 was the combined net result of an $8.2 million increase due to growth in earning assets and a $3.6 million increase due to the increase in yield. The 2005 increase was the combined net result of a $6.1 million increase due to
growth in earning assets and a $1.7 million increase due to the increase in yield. The 2004 increase was the net result of a $2.6 million increase in growth of earning assets and a $536 thousand decrease in yield. Total interest expense increased by
$8.2 million, $4.4 million, and $639 thousand for 2006, 2005, and 2004, respectively. The increase in 2006 was the combined net result of a $4.4 million increase due to growth of interest-bearing liabilities and a $3.8 million increase in rate. The
increase in 2005 was the net result of a $2.5 million increase due to growth of interest-bearing liabilities and a $1.9 million increase in rate. The increase in 2004 was the net result of an $831 thousand increase due to growth in interest-bearing
liabilities and a $192 thousand decrease in rate.



Provision
for Loan Losses.    The Company recorded a $1.3 million, $1.5 million and an $892 thousand provision for loan losses in 2006, 2005 and 2004, respectively. The $159 thousand decrease in the provision for loan losses in 2006 is
a reflection of the moderated growth in total loans outstanding as well as a reduction in nonperforming loans in 2006. The $607 thousand increase in the provision for loan losses for 2005 as compared to the same period in 2004 resulted mainly from
growth in total loans outstanding during 2005. The provision for loan losses also increased by $601 thousand in 2004 due to growth in total loans outstanding. Provisions for loan losses are charged to income to bring the allowance for loan losses to
a level that management deems appropriate. In evaluating the allowance for loan losses, management considers factors that include growth, composition and industry diversification of the portfolio, historical loan loss experience,



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current delinquency levels, adverse situations that may affect a borrowers ability to repay, estimated value of any underlying collateral, prevailing
economic conditions and other relevant factors.



Total loans
outstanding increased by $56.0 million, $116.0 million, and $58.4 million during 2006, 2005, and 2004, respectively. The allowance for loan losses was $4.5 million, $3.5 million, and $2.1 million for 2006, 2005, and 2004, respectively, representing
1.36%, 1.26% and 1.30%, respectively, of loans outstanding, and 1,296.00%, 298.98% and 212.02%, respectively, of nonperforming loans. Although loan growth moderated in 2006, the increase in the percentage of loan loss allowance to total loans
outstanding in the current year is due to managements recognition of the risk associated with the Companys high concentration in construction and commercial real estate lending with the slow down in the real estate market. In 2005 and
2004, the percentage of loan loss allowance to total loans outstanding decreased even with the large growth in loans outstanding. Management believed the overall quality of the remaining portfolio had improved; hence, the level of loan loss
allowance to nonperforming loans increased for the 2005 and 2004 periods. Nonperforming loans to total loans outstanding has decreased each year to 0.10%, 0.42%, and 0.61% for 2006, 2005, and 2004, respectively.



Non-Interest Income.    Non-interest income was
$1.1 million, $1.0 million, and $746 thousand for 2006, 2005, and 2004, respectively. Service fees and charges, which represent a relatively stable and predictable source of non-interest income, totaled $713 thousand, $644 thousand and $540 thousand
for 2006, 2005, and 2004, respectively. Contributing to non-interest income were fees produced by our mortgage origination department, $223 thousand, $203 thousand, and $105 thousand in 2006, 2005, and 2004, respectively, and income from our
investment in bank-owned life insurance, $196 thousand, $199 thousand, and $106 thousand, in 2006, 2005, and 2004, respectively. The Company purchased $5.0 million in bank owned life insurance in July 2004 to fund supplemental retirement benefits
for certain officers and directors under arrangements that were implemented during 2005. The 2006 year included $91 thousand of recovered expenses related to a loan charged off in 2003.



Non-Interest Expenses.    Non-interest expenses totaled $9.3 million, $6.4 million, and $4.6
million for 2006, 2005, and 2004, respectively. As a percentage of average assets, total non-interest expenses remained the same, at 2.35%, for 2006 and 2005, decreasing from 2.82% in 2004. While we added additional overhead related to expanding our
staff and facilities, we aggressively grew our loan portfolio to accommodate the extra expense. Salaries and employee benefits increased the most in this category as a result of personnel additions, normal compensation adjustments, higher costs for
group insurance coverage, and incentive awards made in recognition of our improvement in performance. The number of employees increased by 28, 12, and 14 employees in 2006, 2005, and 2004, respectively. Total salaries and employee benefits increased
by $1.5 million, $861 thousand, and $679 thousand in 2006, 2005, and 2004, respectively. Also, the Company recognized expenses of $298 thousand in 2006 and $211 thousand in 2005 related to the 2005 implementation of supplemental retirement benefits
for certain officers and directors versus none for this activity in 2004. Occupancy and equipment costs increased by $556 thousand, $195 thousand and $109 thousand in 2006, 2005, and 2004, respectively. The large increase in 2006 was due to the
addition of two new full-service branches, one in Pender County and one in Brunswick County, and the leasing of space for the credit administration department. The 2005 occupancy and equipment costs were the result of leasing a support services
facility, expansion of the Hampstead branch and remodeling of the Main Office second floor. The 2004 expenses reflected the addition of the Hampstead branch. Other non-interest expenses increased by $876 thousand, $699 thousand, and $210 thousand
for 2006, 2005, and 2004, respectively. The 2006 increases included an increase of $189 thousand in data processing and other outsourced services as a result of growth, a $227 thousand increase in advertising costs related to the Companys name
change and branch openings, and a $91 thousand non-recurring charge related to changes in check processing vendor. The 2005 increases included an increase of $200 thousand in data processing and other outsourced services as a result of growth and
additional services, an increase of $76 thousand in advertising costs, and an increase of $74 thousand in expenses related to the formation of the holding company. The 2004 expenses included an increase of $48 thousand in data processing and check
processing with branch expansion and a $61 thousand increase in advertising costs. Other increases in each of the years resulted principally from the Companys growth. The Company has further expansion plans for 2007 with the addition of two
new full-service branches, one in New Hanover County and one in Brunswick County. Management believes that salary and occupancy expenses will increase in the near-term as the Company pursues growth in accordance with its strategic plan. Also, data
processing expense is tied closely to transaction and account volumes so these expenses should increase as the Company continues to grow.



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The Company recorded an income tax expense of $1.1 million and $785 thousand for the years ended
December 31, 2006 and 2005, respectively, compared to an income tax benefit of $66 thousand for the year ended December 31, 2004. The difference from 2004 to 2005 is principally due to adjustments to the valuation allowance associated with
deferred tax assets. The Companys effective tax rate was 31.6%, 31.8%, and 32.9% in 2006, 2005, and 2004, respectively. The overall lower effective tax rate in the 2006 and 2005 years is primarily the result of an overall greater proportion of
pre-tax income in those years being comprised of non-taxable income earned on bank owned life insurance and municipal securities.



Average Balances and Average Rates Earned and Paid.Table 1 in the 2006 Form 10-K sets forth, for the periods indicated,
information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest
income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Nonaccrual loans have been included in determining average loans.



Rate/Volume Analysis.Table 2 in the 2006 Form
10-K analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in
volume multiplied by the prior periods rate), (ii) changes attributable to rate (changes in rate multiplied by the prior periods volume), and (iii) net change (the sum of the previous columns). The change attributable to both
rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.



LIQUIDITY AND CAPITAL RESOURCES



The Companys sources of funds are customer deposits, cash and demand balances due from other banks, interest-earning deposits in other banks and investment
securities available for sale. These funds, together with loan repayments, are used to make loans and to fund continuing operations. In addition, the Company had credit availability with the Federal Home Loan Bank of Atlanta (FHLB) of
approximately $63.7 million at December 31, 2006. It also had a credit line with various financial institutions in the amount of $11.6 million in 2006. The Company had $31.0 million and $22.0 million in borrowings outstanding under FHLB
advances at December 31, 2006 and 2005, respectively. In addition, the Company had $10.3 million in subordinated long-term debt payable to the Trust outstanding in both 2006 and 2005. Management utilizes these borrowings to help manage its cash
flow, cost of funds, interest sensitivity and gap position.



Total deposits
were $353.6 million and $284.1 million at December 31, 2006 and 2005, respectively. Because loan demand has exceeded the rate of growth in core deposits, the Company has relied heavily on time deposits as a source of funds. Certificates of
deposit are the only deposit accounts that have stated maturity dates, and those deposits are generally considered to be rate sensitive. At December 31, 2006 and 2005, time deposits represented 75.8% and 77.5%, respectively, of total deposits.
Certificates of deposit of $100 thousand or more represented 37.1% and 33.8%, respectively, of total deposits at December 31, 2006 and 2005. The Company has certificates of deposit acquired by advertising rates on the Internet and some obtained
through deposit brokers. On December 31, 2006, those out-of-market deposits amounted to approximately $94.4 million, or approximately 26.7% of total deposits and approximately 35.2% of total certificates of deposit. On December 31, 2005,
those out-of-market deposits amounted to approximately $83.8 million, or approximately 29.5% of total deposits and approximately 38.1% of total certificates of deposit. The Company uses brokered certificates of deposit as an alternative funding
source. Brokered deposits represent a source of fixed rate funds that do not need to be collateralized like Federal Home Loan Bank borrowings. The Company expects to continue to utilize the brokered deposit market in the future. With the exception
of these out-of-market deposits, management believes most of its other time deposits are relationship-oriented and, while it will be necessary to pay competitive rates to retain those deposits at their maturities, there are other subjective factors
that will determine their continued retention. Based upon prior experience, management anticipates that a substantial portion of outstanding certificates of deposit will renew upon maturity.



Management anticipates that it will rely primarily upon customer deposits,
loan repayments and current earnings to provide liquidity, and will use funds thus generated to make loans and to purchase securities, primarily securities issued by the federal government and its agencies, municipals, and mortgage-backed
securities. As of December 31, 2006, liquid assets (cash and due from banks, interest-earning bank deposits, federal funds sold, time deposits in other banks and investment securities available for sale) were approximately $78.7 million, which
represented 18.5% of total assets and 22.3% of total deposits. At December 31, 2006, outstanding commitments to extend credit were $23.3 million, stand-by



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letters of credit totaled $1.2 million and available line of credit balances totaled $71.2 million. As of December 31, 2005, liquid assets (cash and due
from banks, interest-earning bank deposits, federal funds sold, time deposits in other banks and investment securities available for sale) were approximately $56.1 million, which represented 16.3% of total assets and 19.8% of total deposits.
Management believes that the combined aggregate liquidity position of the Company is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.



The Company and the Bank are subject to minimum capital requirements. The
Selected Financial Information and Other Data table presented prior to this discussion indicates the Companys capital ratios at December 31, 2006. All capital ratios place the Company and the Bank in excess of the minimum necessary to be
considered well capitalized under regulatory guidelines.



ASSET/LIABILITY MANAGEMENT



The Companys
results of operations depend substantially on its net interest income. Like most financial institutions, the Companys interest income and cost of funds are affected by general economic conditions and by competition in the market place.



The purpose of asset/liability management is to provide stable
net interest income growth by protecting the Companys earnings from undue interest rate risk arising from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest
rate risk, market risk, and capital adequacy. The Company maintains, and has complied with, an asset/liability management policy approved by its Board of Directors that provides guidelines for controlling exposure to interest rate risk by utilizing
the following ratios and trend analysis: liquidity, equity, volatile liability dependence, portfolio maturities, maturing assets and maturing liabilities. The Companys policy is to control the exposure of its earnings to changing interest
rates by generally endeavoring to maintain a position within a narrow range around an earnings neutral position, which is defined as the mix of assets and liabilities that generate a net interest margin that is least affected by interest
rate changes.



When suitable lending opportunities are not
sufficient to utilize available funds, the Company has generally invested such funds in securities, primarily securities issued by governmental agencies, municipals, and mortgage-backed securities. Its securities portfolio contributes to profits and
plays an important part in the overall interest rate risk management. However, management of the securities portfolio alone cannot balance overall interest rate risk. The securities portfolio must be used in combination with other asset/liability
techniques to actively manage the balance sheet. The primary objectives in the overall management of the securities portfolio are safety, liquidity, yield, asset/liability management (interest rate risk), and investing in securities that can be
pledged for public deposits.



In reviewing the Companys
needs with regard to proper management of its asset/liability program, management estimates its future needs, taking into consideration historical periods of high loan demand and low deposit balances, estimated loan and deposit increases (due to
increased demand through marketing), and forecasted interest rate changes.



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The analysis of an institutions interest rate gap (the difference between the repricing of
interest-earning assets and interest-bearing liabilities during a given period of time) is a standard tool for the measurement of exposure to interest rate risk. The following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at December 31, 2006 that are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a
particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. In making the gap computations,
assumptions made regarding prepayment rates and deposit decay rates have been used for interest-earning assets or interest-bearing liabilities. Loan prepayment rates were provided by Vining Sparks IBG, L.P.s Portfolio Strategies Group based on
their experience in a national banking market with a normal mix of loans. Deposit decay rates were derived from the proprietary model from the Office of the Comptroller of the Currencys Risk Analysis Division. In addition, the table reflects
scheduled principal payments which will be received throughout the lives of the loans. The interest rate sensitivity of the Companys assets and liabilities illustrated in the following table would vary substantially if different assumptions
were used or if its actual experience differs from that indicated by the assumptions.



|                                                                                  |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|--------------------------------------------------------------------------------- |  | --------------------------------------- | ------- | - | ------------- | - | -------- | ---------------- |  | - | ----------- | - |  | ----- | ------ | - |  | - | ------- | -
|                                                                                  |  | Terms to Repricing at December 31, 2006 |        
|                                                                                  |  | Within 3Months                          |         |   | 4 to 12Months |   |          | 1 Year to5 Years |  |   | Over 5Years |   |  | Total |       
|                                                                                  |  | (Dollars in thousands)                  |        
|Interest-earning assets:                                                          |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Loans receivable:                                                                 |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Adjustable rate                                                                   |  | $                                       | 212,855 |   |               | $ |         |                  |  | $ | 4           |   |  | $     | 50     |   |  | $ | 212,909 |  
|Fixed rate                                                                        |  |                                         | 14,695  |   |               |   | 19,092   |                  |  |   | 86,937      |   |  |       | 776    |   |  |   | 121,500 |  
|Investment securities available for sale                                          |  |                                         | 944     |   |               |   | 2,733    |                  |  |   | 29,076      |   |  |       | 36,812 |   |  |   | 69,565  |  
|Interest-earning and time deposits in other banks                                 |  |                                         | 1,738   |   |               |   | 99       |                  |  |   | 100         |   |  |       |       |   |  |   | 1,937   |  
|Stock in FHLB of Atlanta                                                          |  |                                         | 2,081   |   |               |   |         |                  |  |   |            |   |  |       |       |   |  |   | 2,081   |  
|                                                                                  |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Total interest-earning assets                                                     |  | $                                       | 232,313 |   |               | $ | 21,924   |                  |  | $ | 116,117     |   |  | $     | 37,638 |   |  | $ | 407,992 |  
|                                                                                  |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Interest-bearing liabilities:                                                     |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Deposits:                                                                         |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Money market, NOW and savings                                                     |  | $                                       | 7,301   |   |               | $ | 16,687   |                  |  | $ | 28,483      |   |  | $     |       |   |  | $ | 52,471  |  
|Time                                                                              |  |                                         | 31,250  |   |               |   | 89,543   |                  |  |   | 16,255      |   |  |       |       |   |  |   | 137,048 |  
|Time over $100,000                                                                |  |                                         | 26,305  |   |               |   | 72,828   |                  |  |   | 31,899      |   |  |       |       |   |  |   | 131,032 |  
|Borrowings                                                                        |  |                                         | 24,310  |   |               |   | 3,000    |                  |  |   | 6,000       |   |  |       | 8,000  |   |  |   | 41,310  |  
|                                                                                  |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Total interest-bearing liabilities                                                |  | $                                       | 89,166  |   |               | $ | 182,058  |                  |  | $ | 82,637      |   |  | $     | 8,000  |   |  | $ | 361,861 |  
|                                                                                  |  |                                         |         |   |               |   |          |                  |  |   |             |   |  |       |        |   |  |   |         |  
|Interest sensitivity gap per period                                               |  | $                                       | 143,147 |   |               | $ | (160,134 | )                |  | $ | 33,480      |   |  | $     | 29,638 |   |  | $ | 46,131  |  
|Cumulative interest sensitivity gap                                               |  | $                                       | 143,147 |   |               | $ | (16,987  | )                |  | $ | 16,493      |   |  | $     | 46,131 |   |  | $ | 46,131  |  
|Cumulative gap as a percentage of total interst-earning assets                    |  |                                         | 35.09   | % |               |   | -4.16    | %                |  |   | 4.04        | % |  |       | 11.31  | % |  |   | 11.31   | %
|Cumulative interst-earning assets as a percentage of interest-bearing liabilities |  |                                         | 260.54  | % |               |   | 93.74    | %                |  |   | 104.66      | % |  |       | 112.75 | % |  |   | 112.75  | %



MARKET RISK



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



Table 6 in the 2006 Form 10-K sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding
at December 31, 2006, which are projected to reprice or mature in each of the future time periods shown.



Note M to the Companys audited consolidated financial statements presents information about the contractual maturities, average interest rates and
estimated fair values of our financial instruments that are considered market risk sensitive at December 31, 2006.



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CRITICAL ACCOUNTING POLICIES



This discussion and analysis of financial condition and results of operations is based on the Companys financial
statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of the Companys financial statements requires management to make estimates and judgments regarding
uncertainties that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, management evaluates its estimates which are based upon historical experience and on other assumptions that it believes to be
reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.



The Companys significant accounting policies are described in Note B to its audited consolidated financial statements. The Company considers the
following accounting policies to be most critical in their potential effect on its financial position or results of operations:



Allowance for Loan Losses.The most critical estimate concerns the Companys allowance for loan losses. It
records provisions for loan losses based upon known problem loans and estimated deficiencies in the existing loan portfolio. Its methodology for assessing the allowance for loan losses consists of two key components, including a specific allowance
for identified problem or impaired loans and a formula allowance for the remainder of the portfolio.



Identified problem and impaired loans are measured for impairment based on the present value of expected future cash flows discounted at the loans
effective interest rate, the loans observable market price or the fair value of the collateral if the loan is collateral dependent. This evaluation is inherently subjective as it requires material estimates that may be susceptible to
significant change. The adequacy of the allowance is also reviewed by the management based upon its evaluation of then-existing economic and business conditions affecting its key lending areas and other conditions, such as new loan products,
collateral values, loan concentrations, changes in the mix and volume of the loan portfolio; trends in portfolio credit quality, including delinquency and charge-off rates; and current economic conditions that may affect a borrowers ability to
repay. Although management believes it has established and maintained the allowance for loan losses at appropriate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current
operating environment.



Interest Income
Recognition.Interest on loans is included in income as earned based upon interest rates applied to unpaid principal. Interest is not accrued on loans 90 days or more past due unless the loans are adequately secured
and in the process of collection. Interest is not accrued on other loans when management believes collection is doubtful. All loans considered impaired are non-accruing. Interest on non-accruing loans is recognized as payments are received when the
ultimate collectibility of interest is no longer considered doubtful. When a loan is placed on non-accrual status, all interest previously accrued is reversed against current-period interest income.



OFF-BALANCE SHEET ARRANGEMENTS



Information about the Companys off-balance sheet risk exposure is
presented in Note L to the accompanying financial statements. As part of its ongoing business, the Company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities
often referred to as special purpose entities (SPEs), which generally are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2006, the Company is not
involved in any unconsolidated SPE transactions.



ADDITIONAL FINANCIAL
INFORMATION



Loans Receivable



Table 7 in the 2006 Form 10-K sets forth, at the dates indicated, the
Companys loan portfolio composition by type of loan.



Table 8 in the 2006 Form 10-K presents at December 31, 2006 (1) the aggregate maturities of loans in the named categories of the Companys loan portfolio and (2) the aggregate amounts of variable and fixed rate loans
that mature after one year.



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Asset Quality



Maintaining a high level of asset quality is a primary goal in the Companys lending function, and it employs a formal internal loan review process
to ensure adherence to the lending policies approved by its Board of Directors. A systematic evaluation process fundamentally drives the function of determining the allowance for loan losses. This ongoing process serves as the basis for determining,
on a monthly basis, the allowance for loan losses and any resulting provision to be charged against earnings. Consideration is given to historical loan loss experience, the value and adequacy of collateral, economic conditions in its market area and
other factors. For loans determined to be impaired, the allowance is based on discounted cash flows using the loans initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation is
inherently subjective as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses represents
managements estimate of the appropriate level of reserve to provide for probable losses inherent in the loan portfolio.



The Companys policy regarding past due loans normally requires a prompt charge-off to the allowance for loan losses following timely collection
efforts and a thorough review. Further efforts are then pursued through various means available. Loans carried in a non-accrual status are generally collateralized, and probable losses are considered in the determination of the allowance for loan
losses.



Nonperforming Assets



Table 9 in the 2006 Form 10-K sets forth information with respect to the
Companys nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans plus restructured loans), and total nonperforming assets.



Nonperforming assets decreased by $208 thousand or 17.7% in 2006. Total nonperforming assets in 2006 included real estate with a carrying value of $616
thousand acquired through foreclosure in August 2006. It is currently under contract, anticipated to close in the first quarter of 2007, and management expects to recover its current value in the property. Although nonperforming assets decreased in
2006, the allowance for loan losses has increased. This is a result of managements recognition of the increased risk of its concentration in construction and commercial real estate loans in a moderating real estate market. The allowance for
loan losses to total outstanding loans was 1.36% but the allowance for loan losses to nonperforming loans is 1,296.00% at December 31, 2006. Nonperforming assets to total assets was 0.23% at December 31, 2006. Though nonperforming loans
increased by $181 thousand, or by approximately 18.2%, from December 31, 2004 to December 31, 2005, the amount of nonperforming loans as a percentage of total loans decreased from 0.61% to 0.42% during the same period. At year end 2006,
one loan, secured by real estate, for approximately $160 thousand made up 45.7% of nonperforming loans. An aggregate of approximately 77.0% of nonperforming loans at December 31, 2005 consisted of two loans amounting to an aggregate of
approximately $904 thousand. One of these loans totaling approximately $640 thousand is secured by real estate and is the current foreclosure in 2006.



The Companys financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on its loan
portfolio, unless a loan is placed on a nonaccrual basis. Loans are placed on a nonaccrual basis when they become 90 days past due or whenever it believes that collection has become doubtful. Amounts received on non-accrual loans generally are
applied first to principal and then to interest only after all principal has been collected. Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the
deferral of interest or principal, have been granted due to the borrowers weakened financial condition. Interest on restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur.
Loans are charged off when the collection of principal and interest has become doubtful and the loans no longer can be considered sound collectible assets (or, in the case of unsecured loans, when they become 90 days past due).



Interest on nonaccrual loans foregone was approximately $113 thousand, $76
thousand, and $38 thousand for the years ended December 31, 2006, 2005, and 2004, respectively.



Allowance for Loan Losses



The allowance for loan losses is maintained at a level considered adequate by management to provide for anticipated loan losses based on managements assessment of various factors affecting the loan portfolio, including a review of



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problem loans, business conditions and loss experience and an overall evaluation of the quality of the underlying collateral. The allowance is increased by
provisions charged to operations and reduced by loans charged off, net of recoveries.



While management believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net
income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. In addition, various regulatory agencies may require us to make adjustments to the allowance for loan losses
based on their judgments about information available to them at the time of their examination. Table 10 in the 2006 Form 10-K shows the allocation of the Companys allowance for loan losses at the dates indicated. The allocation is based on an
evaluation of defined loan problems, historical ratios of loan losses and other factors that may affect future loan losses in the categories of loans shown.



Table 11 in the 2006 Form 10-K sets forth for the periods indicated information regarding changes in the Companys allowance for loan losses.



Investments



The Companys portfolio of investment securities, all of which are
available for sale, consists of U.S. government agency securities, municipals, corporate bonds, and mortgage-backed securities (including collateralized mortgage obligations). Securities to be held for indefinite periods of time and not intended to
be held to maturity are classified as available for sale and carried at fair value with any unrealized gains or losses reflected as an adjustment to shareholders equity. Securities held for indefinite periods of time include securities that
management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates and/or significant prepayment risks. It is the Companys policy to classify all investment securities as
available for sale.



Table 13 in the 2006 Form 10-K provides
the amortized costs, carrying values, intervals of maturities or repricings, and weighted average yields of the Companys investment portfolio at December 31, 2006. The weighted average yields have not been calculated on a tax equivalent
basis.



For purposes of the maturity table, mortgage-backed
securities, which are not due at a single maturity date, have been allocated over maturity groupings based on the weighted-average contractual maturities of underlying collateral. The mortgage-backed securities may mature earlier than their
weighted-average contractual maturities because of principal prepayments.



The Company does not engage in, nor does it presently intend to engage in, securities trading activities and, therefore, it does not maintain a trading account. At December 31, 2006 and 2005, there were no
securities of any issuer (other than governmental agencies) that exceeded 10% of the Companys shareholders equity.



Deposits



Table 14 in the 2006 Form 10-K sets forth for the periods indicated the average balances outstanding and average interest rates for each major category of
deposits.



Table 15 in the 2006 Form 10-K sets forth the
amounts and maturities of the Companys certificates of deposit.



Borrowings



As an additional source of
funding, the Company uses advances from the Federal Home Loan Bank of Atlanta under a line of credit with a maximum borrowing availability of $63.7 million and $51.4 million at December 31, 2006 and 2005, respectively. Advances are secured by
loans and investments. The Company had $31.0 million and $22.0 million in advances outstanding at Federal Home Loan Bank at December 31, 2006 and 2005, respectively.



The Company also had $10.3 million in long-term subordinated debentures outstanding payable to its unconsolidated
subsidiary, BKWW Statutory Trust I, at December 31, 2006 and 2005.



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In addition, the Company may purchase federal funds through unsecured federal funds lines of credit
totaling $11.0 million at December 31, 2006 and 2005. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and term of advances. These lines of credit are payable on demand and bear interest
based upon the daily federal funds rate. The Company had no advances outstanding against these lines of credit at December 31, 2006 and 2005.



The Company maintains a credit facility with the Federal Reserve Bank of Richmond under which it has a maximum borrowing availability of approximately
$563 thousand and $659 thouand at December 31, 2006 and 2005, respectively. The line of credit is secured by an investment security available for sale. No amount was outstanding under this line of credit at December 31, 2006 and 2005.



RECENT ACCOUNTING PRONOUNCEMENTS



See Note B to the consolidated financial statements for a full description
of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition.



FORWARD-LOOKING INFORMATION



This Annual Report includes forward-looking statements. Statements in this Report relating to plans, strategies, economic performance and trends,
projections of results of specific activities or investments, expectations or beliefs about future events or results, and other statements that are not descriptions of historical facts, may be forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking information is inherently subject to risks and uncertainties, and actual
results could differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in reports we file with the U. S. Securities and Exchange Commission from time to time.
Forward-looking statements may be identified by terms such as may, will, should, could, expects, plans, intends, anticipates, believes,
estimates, predicts, forecasts, potential or continue, or similar terms or the negative of these terms, or other statements concerning opinions or judgments of our management about future
events. Factors that could influence the accuracy of those forward-looking statements include, but are not limited to, the financial success or changing strategies of the customers; customer acceptance of the Companys services, products and
fee structure; the competitive nature of the financial services industry and the Companys ability to compete effectively against other financial institutions in the Companys banking market; actions of government regulators; the ability
to manage the Companys growth and to underwrite increasing volumes of loans; the impact on profits of increased staffing and expenses resulting from expansion; the level of market interest rates and the ability to manage the Companys
interest rate risk; weather and similar conditions, particularly the effect of hurricanes on the banking and operations facilities and on the customers and the coastal communities in which the Company does business; changes in general economic
conditions and the real estate market in the banking market (particularly changes that affect the loan portfolio, the abilities of borrowers to repay loans, and the values of loan collateral); and other developments or changes in the business that
are unexpected. Although management believes that the expectations reflected in the forward-looking statements are reasonable, they are not guaranteed future results, levels of activity, performance or achievements. The Company has no obligation to
update these forward-looking statements.



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LOGO



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors

Cape Fear Bank Corporation

Wilmington, North Carolina



We have audited the
accompanying consolidated balance sheets of Cape Fear Bank Corporation and subsidiary (the Company) as of December 31, 2006 and 2005 and the related consolidated statements of operations, comprehensive income, changes in
shareholders equity, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express
an opinion on these consolidated financial statements based on our audits.



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



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



LOGO



Greenville, North Carolina

March 20, 2007



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS



December 31, 2006 and 2005



|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                                                                               |  | 2006                              |         |   | 2005 |  
|                                                                                                                                                               |  | (In thousands, except share data) |        
|ASSETS                                                                                                                                                         |  |                                   |         |   |      |   |         |  
|Cash and due from banks                                                                                                                                        |  | $                                 | 7,209   |   |      | $ | 1,854   |  
|Interest earning deposits in other banks                                                                                                                       |  |                                   | 1,639   |   |      |   | 5,419   |  
|Investment securities available for sale, at fair value                                                                                                        |  |                                   | 69,565  |   |      |   | 48,655  |  
|Time deposits in other banks                                                                                                                                   |  |                                   | 298     |   |      |   | 199     |  
|Loans                                                                                                                                                          |  |                                   | 334,409 |   |      |   | 278,386 |  
|Allowance for loan losses                                                                                                                                      |  |                                   | (4,536  | ) |      |   | (3,510  | )
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Net Loans                                                                                                                                                      |  |                                   | 329,873 |   |      |   | 274,876 |  
|Accrued interest receivable                                                                                                                                    |  |                                   | 2,195   |   |      |   | 1,645   |  
|Premises and equipment, net                                                                                                                                    |  |                                   | 2,954   |   |      |   | 1,845   |  
|Stock in Federal Home Loan Bank of Atlanta, at cost                                                                                                            |  |                                   | 2,081   |   |      |   | 1,394   |  
|Foreclosed real estate and repossessions                                                                                                                       |  |                                   | 616     |   |      |   |        |  
|Bank owned life insurance                                                                                                                                      |  |                                   | 5,491   |   |      |   | 5,296   |  
|Other assets                                                                                                                                                   |  |                                   | 2,964   |   |      |   | 2,144   |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Total Assets                                                                                                                                                   |  | $                                 | 424,885 |   |      | $ | 343,327 |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                           |  |                                   |         |   |      |   |         |  
|Deposits                                                                                                                                                       |  |                                   |         |   |      |   |         |  
|Demand                                                                                                                                                         |  | $                                 | 33,066  |   |      | $ | 26,025  |  
|Savings                                                                                                                                                        |  |                                   | 11,154  |   |      |   | 2,594   |  
|Money market and NOW                                                                                                                                           |  |                                   | 41,317  |   |      |   | 35,339  |  
|Time                                                                                                                                                           |  |                                   | 268,080 |   |      |   | 220,176 |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Total Deposits                                                                                                                                                 |  |                                   | 353,617 |   |      |   | 284,134 |  
|Short-term borrowings                                                                                                                                          |  |                                   | 3,000   |   |      |   |        |  
|Long-term borrowings                                                                                                                                           |  |                                   | 38,310  |   |      |   | 32,310  |  
|Accrued interest payable                                                                                                                                       |  |                                   | 745     |   |      |   | 457     |  
|Accrued expenses and other liabilities                                                                                                                         |  |                                   | 2,161   |   |      |   | 1,791   |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Total Liabilities                                                                                                                                              |  |                                   | 397,833 |   |      |   | 318,692 |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Shareholders Equity                                                                                                                                           |  |                                   |         |   |      |   |         |  
|Common stock, $3.50 par value, 12,500,000 shares authorized; 3,586,780 and 3,586,871 shares issued and outstanding at December 31, 2006
and 2005, respectively |  |                                   | 12,554  |   |      |   | 11,956  |  
|Additional paid-in capital                                                                                                                                     |  |                                   | 12,739  |   |      |   | 11,052  |  
|Accumulated retained earnings                                                                                                                                  |  |                                   | 2,092   |   |      |   | 2,153   |  
|Accumulated other comprehensive loss                                                                                                                           |  |                                   | (333    | ) |      |   | (526    | )
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Total shareholders equity                                                                                                                                     |  |                                   | 27,052  |   |      |   | 24,635  |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  
|Total liabilities and shareholders equity                                                                                                                     |  | $                                 | 424,885 |   |      | $ | 343,327 |  
|                                                                                                                                                               |  |                                   |         |   |      |   |         |  



See accompanying notes.



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS



Years Ended December 31, 2006, 2005 and 2004



|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|--------------------------------------------------- |  | ------------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ----- | -
|                                                    |  | 2006                                  |        |   | 2005 |   |        | 2004 | 
|                                                    |  | (In thousands, except per share data) |       
|INTEREST INCOME                                     |  |                                       |        |   |      |   |        |      |  |   |       |  
|Loans                                               |  | $                                     | 24,857 |   |      | $ | 14,728 |      |  | $ | 7,663 |  
|Investment securities available for sale            |  |                                       | 2,816  |   |      |   | 1,453  |      |  |   | 855   |  
|Other interest-earning assets                       |  |                                       | 523    |   |      |   | 231    |      |  |   | 78    |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Total Interest income                               |  |                                       | 28,196 |   |      |   | 16,412 |      |  |   | 8,596 |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|INTEREST EXPENSE                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Money market, NOW and savings deposits              |  |                                       | 1,681  |   |      |   | 619    |      |  |   | 267   |  
|Time deposits                                       |  |                                       | 11,800 |   |      |   | 5,702  |      |  |   | 2,378 |  
|Short-term borrowings                               |  |                                       | 115    |   |      |   |       |      |  |   | 97    |  
|Long-term borrowings                                |  |                                       | 1,706  |   |      |   | 792    |      |  |   |      |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Total interest expense                              |  |                                       | 15,302 |   |      |   | 7,113  |      |  |   | 2,742 |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Net interest income                                 |  |                                       | 12,894 |   |      |   | 9,299  |      |  |   | 5,854 |  
|Provision for loan losses                           |  |                                       | 1,340  |   |      |   | 1,499  |      |  |   | 892   |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Net interest income after provision for loan losses |  |                                       | 11,554 |   |      |   | 7,800  |      |  |   | 4,962 |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|NON INTEREST INCOME                                 |  |                                       |        |   |      |   |        |      |  |   |       |  
|Service fees and charges                            |  |                                       | 713    |   |      |   | 644    |      |  |   | 540   |  
|Loss on sale of investments                         |  |                                       | (60    | ) |      |   | (10    | )    |  |   | (5    | )
|Income from bank owned life insurance               |  |                                       | 195    |   |      |   | 199    |      |  |   | 97    |  
|Other                                               |  |                                       | 245    |   |      |   | 215    |      |  |   | 114   |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Total non-interest income                           |  |                                       | 1,093  |   |      |   | 1,048  |      |  |   | 746   |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|NON INTEREST EXPENSE                                |  |                                       |        |   |      |   |        |      |  |   |       |  
|Salaries and employee benefits                      |  |                                       | 4,949  |   |      |   | 3,438  |      |  |   | 2,577 |  
|Occupancy and equipment                             |  |                                       | 1,533  |   |      |   | 977    |      |  |   | 782   |  
|Other (Note J)                                      |  |                                       | 2,842  |   |      |   | 1,966  |      |  |   | 1,267 |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Total non-interest expense                          |  |                                       | 9,324  |   |      |   | 6,381  |      |  |   | 4,626 |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Income before income taxes                          |  |                                       | 3,323  |   |      |   | 2,467  |      |  |   | 1,082 |  
|Income taxes (benefit)                              |  |                                       | 1,051  |   |      |   | 785    |      |  |   | (66   | )
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Net income                                          |  | $                                     | 2,272  |   |      | $ | 1,682  |      |  | $ | 1,148 |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|NET INCOME PER COMMON SHARE                         |  |                                       |        |   |      |   |        |      |  |   |       |  
|Basic                                               |  | $                                     | 0.63   |   |      | $ | 0.47   |      |  | $ | 0.39  |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  
|Diluted                                             |  | $                                     | 0.61   |   |      | $ | 0.46   |      |  | $ | 0.38  |  
|                                                    |  |                                       |        |   |      |   |        |      |  |   |       |  



See accompanying notes.



23



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##### Table of Contents

CAPE FEAR BANK CORPORATON AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME



Years Ended December 31, 2006, 2005 and 2004



|                                                                                           |  |                |       |   |      |   |       |      |  |   |       |  
|------------------------------------------------------------------------------------------ |  | -------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|                                                                                           |  | 2006           |       |   | 2005 |   |       | 2004 | 
|                                                                                           |  | (In thousands) |      
|NET INCOME                                                                                 |  | $              | 2,272 |   |      | $ | 1,682 |      |  | $ | 1,148 |  
|                                                                                           |  |                |       |   |      |   |       |      |  |   |       |  
|OTHER COMPREHENSIVE INCOME (LOSS)                                                          |  |                |       |   |      |   |       |      |  |   |       |  
|Unrealized gain (loss) on investment securities available for sale arising during the year |  |                | 253   |   |      |   | (768  | )    |  |   | (77   | )
|Tax effect                                                                                 |  |                | (97   | ) |      |   | 295   |      |  |   | 39    |  
|Reclassification of losses recognized in net income                                        |  |                | 60    |   |      |   | 10    |      |  |   | 5     |  
|Tax effect                                                                                 |  |                | (23   | ) |      |   | (4    | )    |  |   | (2    | )
|                                                                                           |  |                |       |   |      |   |       |      |  |   |       |  
|Total other comprehensive income (loss)                                                    |  |                | 193   |   |      |   | (467  | )    |  |   | (35   | )
|                                                                                           |  |                |       |   |      |   |       |      |  |   |       |  
|Comprehensive income                                                                       |  | $              | 2,465 |   |      | $ | 1,215 |      |  | $ | 1,113 |  
|                                                                                           |  |                |       |   |      |   |       |      |  |   |       |  



See accompanying notes.



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY



Years Ended December 31, 2006, 2005 and 2004



|                                   |  |                                   |   |  |                            |        |                                       |  |   |                                    |  |   |              |   |  |   |      |   |  |   |        |  
|---------------------------------- |  | --------------------------------- | - |  | -------------------------- | ------ | ------------------------------------- |  | - | ---------------------------------- |  | - | ------------ | - |  | - | ---- | - |  | - | ------ | -
|                                   |  | Common stock                      |   |  | Additional Paid-in Capital |        | Accumulatedretainedearnings (deficit) |  |   | Accumulatedothercomprehensive loss |  |   | Total equity |  
|                                   |  | Shares                            |   |  | Amount                     |        |                                       |  |   |                                   
|                                   |  | (In thousands, except share data) |  
|Balance at December 31, 2003       |  | 2,841,729                         |   |  | $                          | 9,472  |                                       |  | $ | 7,942                              |  | $ | (677         | ) |  | $ | (24  | ) |  | $ | 16,713 |  
|Net income                         |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   | 1,148        |   |  |   |     |   |  |   | 1,148  |  
|Other comprehensive loss           |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   |             |   |  |   | (35  | ) |  |   | (35    | )
|Sale of common stock               |  | 732,925                           |   |  |                            | 2,443  |                                       |  |   | 3,066                              |  |   |             |   |  |   |     |   |  |   | 5,509  |  
|Exercise of stock options          |  | 788                               |   |  |                            | 3      |                                       |  |   |                                   |  |   |             |   |  |   |     |   |  |   | 3      |  
|                                   |  |                                   |   |  |                            |        |                                       |  |   |                                    |  |   |              |   |  |   |      |   |  |   |        |  
|Balance at December 31, 2004       |  | 3,575,442                         |   |  |                            | 11,918 |                                       |  |   | 11,008                             |  |   | 471          |   |  |   | (59  | ) |  |   | 23,338 |  
|Net income                         |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   | 1,682        |   |  |   |     |   |  |   | 1,682  |  
|Other comprehensive loss           |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   |             |   |  |   | (467 | ) |  |   | (467   | )
|Sale/(Repurchase) of common stock  |  | (317                              | ) |  |                            | (1     | )                                     |  |   | 1                                  |  |   |             |   |  |   |     |   |  |   |       |  
|Exercise of stock options          |  | 11,746                            |   |  |                            | 39     |                                       |  |   | 43                                 |  |   |             |   |  |   |     |   |  |   | 82     |  
|                                   |  |                                   |   |  |                            |        |                                       |  |   |                                    |  |   |              |   |  |   |      |   |  |   |        |  
|Balance at December 31, 2005       |  | 3,586,871                         |   |  |                            | 11,956 |                                       |  |   | 11,052                             |  |   | 2,153        |   |  |   | (526 | ) |  |   | 24,635 |  
|Net income                         |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   | 2,272        |   |  |   |     |   |  |   | 2,272  |  
|Other comprehensive income         |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   |             |   |  |   | 193  |   |  |   | 193    |  
|Adjustment for adoption of SAB 108 |  |                                  |   |  |                            |       |                                       |  |   |                                   |  |   | (162         | ) |  |   |     |   |  |   | (162   | )
|5% Stock dividend                  |  |                                  |   |  |                            | 597    |                                       |  |   | 1,569                              |  |   | (2,166       | ) |  |   |     |   |  |   |       |  
|Stock based compensation expense   |  |                                  |   |  |                            |       |                                       |  |   | 118                                |  |   |             |   |  |   |     |   |  |   | 118    |  
|Cash paid for fractional shares    |  | (353                              | ) |  |                            |       |                                       |  |   |                                   |  |   | (5           | ) |  |   |     |   |  |   | (5     | )
|Exercise of stock options          |  | 262                               |   |  |                            | 1      |                                       |  |   |                                   |  |   |             |   |  |   |     |   |  |   | 1      |  
|                                   |  |                                   |   |  |                            |        |                                       |  |   |                                    |  |   |              |   |  |   |      |   |  |   |        |  
|Balance at December 31, 2006       |  | 3,586,780                         |   |  | $                          | 12,554 |                                       |  | $ | 12,739                             |  | $ | 2,092        |   |  | $ | (333 | ) |  | $ | 27,052 |  
|                                   |  |                                   |   |  |                            |        |                                       |  |   |                                    |  |   |              |   |  |   |      |   |  |   |        |  



See accompanying notes.



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS



Years Ended December 31, 2006, 2005 and 2004



|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|--------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | -------- | ---- |  | - | ------- | -
|                                                                                  |  | Years EndedDecember 31, |        
|                                                                                  |  | 2006                    |         |   | 2005 |   |          | 2004 | 
|                                                                                  |  | (In thousands)          |        
|CASH FLOWS FROM OPERATING ACTIVITIES                                              |  |                         |         |   |      |   |          |      |  |   |         |  
|Net income                                                                        |  | $                       | 2,272   |   |      | $ | 1,682    |      |  | $ | 1,148   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                         |         |   |      |   |          |      |  |   |         |  
|Depreciation and amortization                                                     |  |                         | 462     |   |      |   | 324      |      |  |   | 259     |  
|Deferred Income Taxes                                                             |  |                         | (613    | ) |      |   | (354     | )    |  |   | (390    | )
|Realized loss on investment securities available for sale                         |  |                         | 60      |   |      |   | 10       |      |  |   | 5       |  
|Income from bank owned life insurance                                             |  |                         | (195    | ) |      |   | (199     | )    |  |   | (97     | )
|Gain on sale of foreclosed real estate                                            |  |                         |        |   |      |   | (8       | )    |  |   |        |  
|Provision for loan losses                                                         |  |                         | 1,340   |   |      |   | 1,499    |      |  |   | 892     |  
|Loss on disposal of equipment                                                     |  |                         | 5       |   |      |   |         |      |  |   |        |  
|Stock based compensation                                                          |  |                         | 118     |   |      |   |         |      |  |   |        |  
|Change in assets and liabilities:                                                 |  |                         |         |   |      |   |          |      |  |   |         |  
|Increase in accrued interest receivable                                           |  |                         | (550    | ) |      |   | (911     | )    |  |   | (271    | )
|Increase in other assets                                                          |  |                         | (410    | ) |      |   | (570     | )    |  |   | (108    | )
|Increase in accrued interest payable                                              |  |                         | 288     |   |      |   | 315      |      |  |   | 72      |  
|Increase in accrued expenses and other liabilities                                |  |                         | 207     |   |      |   | 1,306    |      |  |   | 59      |  
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|Net cash provided by operating activities                                         |  |                         | 2,984   |   |      |   | 3,094    |      |  |   | 1,569   |  
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                              |  |                         |         |   |      |   |          |      |  |   |         |  
|Purchase of available for sale investment securities                              |  |                         | (31,301 | ) |      |   | (32,190  | )    |  |   | (16,631 | )
|Proceeds from calls and maturity of securities available for sale                 |  |                         | 5,337   |   |      |   | 5,175    |      |  |   | 4,833   |  
|Proceeds from sales of securities available for sale                              |  |                         | 5,255   |   |      |   | 3,943    |      |  |   | 3,394   |  
|Net increase in loans from originations and repayments                            |  |                         | (56,953 | ) |      |   | (116,326 | )    |  |   | (59,007 | )
|Purchases of bank premises and equipment                                          |  |                         | (1,440  | ) |      |   | (933     | )    |  |   | (274    | )
|Proceeds from sale of foreclosed real estate                                      |  |                         |        |   |      |   | 447      |      |  |   | 8       |  
|Purchase bank owned life insurance                                                |  |                         |        |   |      |   |         |      |  |   | (5,000  | )
|Purchase of time deposits in other banks                                          |  |                         | (99     | ) |      |   | (199     | )    |  |   | 200     |  
|Net purchases of FHLB stock                                                       |  |                         | (687    | ) |      |   | (801     | )    |  |   | (263    | )
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|Net cash used by investing activities                                             |  |                         | (79,888 | ) |      |   | (140,884 | )    |  |   | (72,740 | )
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                              |  |                         |         |   |      |   |          |      |  |   |         |  
|Net increase in deposits                                                          |  |                         | 69,483  |   |      |   | 113,966  |      |  |   | 64,091  |  
|Net increase in short-term borrowings                                             |  |                         | 3,000   |   |      |   | (7,400   | )    |  |   | 900     |  
|Net increase in long-term borrowings                                              |  |                         | 6,000   |   |      |   | 32,310   |      |  |   |        |  
|Proceeds from exercise of stock options                                           |  |                         | 1       |   |      |   | 82       |      |  |   | 3       |  
|Proceeds from issuance of common stock                                            |  |                         |        |   |      |   |         |      |  |   | 5,509   |  
|Cash paid for fractional shares                                                   |  |                         | (5      | ) |      |   |         |      |  |   |        |  
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|Net cash provided by financing activities                                         |  |                         | 78,479  |   |      |   | 138,958  |      |  |   | 70,503  |  
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                              |  |                         | 1,575   |   |      |   | 1,168    |      |  |   | (668    | )
|Cash and cash equivalents, beginning                                              |  |                         | 7,273   |   |      |   | 6,105    |      |  |   | 6,773   |  
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|Cash and cash equivalents, ending                                                 |  | $                       | 8,848   |   |      | $ | 7,273    |      |  | $ | 6,105   |  
|                                                                                  |  |                         |         |   |      |   |          |      |  |   |         |  
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION                                 |  |                         |         |   |      |   |          |      |  |   |         |  
|Interest paid                                                                     |  | $                       | 15,019  |   |      | $ | 6,828    |      |  | $ | 2,670   |  
|Cash paid for income taxes                                                        |  |                         | 2,449   |   |      |   | 275      |      |  |   | 326     |  
|SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIES            |  |                         |         |   |      |   |          |      |  |   |         |  
|Unrealized holding gains (losses) on available-for-sale securities, net of taxes  |  | $                       | 193     |   |      | $ | (467     | )    |  | $ | (35     | )
|Transfers from loans to foreclosed real estate                                    |  |                         | 616     |   |      |   | 200      |      |  |   | 203     |  



See accompanying notes



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



December 31, 2006, 2005 and 2004



NOTE AORGANIZATION
AND OPERATIONS



Bank of Wilmington was incorporated
May 26, 1998 and began banking operations on June 22, 1998. Bank of Wilmington Corporation, a North Carolina-chartered bank holding company, was incorporated on June 20, 2005 for the sole purpose of serving as the parent bank holding
company for Bank of Wilmington. On September 1, 2005, Bank of Wilmington Corporation completed a corporate reorganization in which Bank of Wilmington became its wholly-owned subsidiary. Upon formation, one share of Bank of Wilmingtons
$3.50 par value common stock was exchanged for one newly issued share of Bank of Wilmington Corporations $3.50 par value common stock. Effective on October 1, 2006, the corporate name was changed from Bank of Wilmington Corporation to
Cape Fear Bank Corporation (the Company) and the corporate name of its banking subsidiary was changed from Bank of Wilmington to Cape Fear Bank (the Bank). The Bank is engaged in general commercial and retail banking in
southeastern North Carolina, principally New Hanover, Pender and Brunswick Counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation and the North Carolina Commissioner of
Banks. The Bank undergoes periodic examinations by those regulatory authorities. The Company is regulated by the Federal Reserve Board. On October 4, 2005, the Company formed a new unconsolidated wholly-owned subsidiary, BKWW Statutory Trust I
(the Trust), a Delaware statutory trust, to facilitate the issuance of trust preferred securities. All significant intercompany transactions have been eliminated. The Trust is not consolidated in these financial statements due to the
adoption of FASB Interpretation No. (FIN) 46, Consolidation of Variable Interest Entities. The junior subordinated debentures issued by the Company to the Trust are included in long-term borrowings and the Companys equity interest
in the Trust is included in other assets. The Banks primary source of revenue is derived from loans to customers who are predominately individuals and small to medium-size businesses in its market area.



NOTE BSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



The following is a description of the significant accounting and reporting
policies the Company follows in preparing and presenting its consolidated financial statements.



Effects of Stock Split



The Company declared a 5% stock dividend which was distributed on June 30, 2006. All references to per share results and weighted average common and common equivalent shares outstanding have been adjusted to reflect the effects of this
stock dividend. On June 30, 2005, the Company declared a 5 for 4 stock split in the form of a 25% stock dividend. The effects of the 2006 stock dividend and 2005 stock split have been reflected in the Companys balance sheets as of
December 31, 2006 and 2005.



Use of Estimates



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



Cash and
Cash Equivalents



For the purpose of presentation in the
consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet captions Cash and due from banks and Interest-earning deposits in other banks. Federal regulations
require institutions to set aside specified amounts of cash as reserves against transaction and time deposits. As of December 31, 2006, the daily average gross reserve requirement was $948 thousand.



27



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



Investment Securities Available for Sale



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



Loans



Loans that management has the intent and ability to hold
for the foreseeable future or until maturity are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on
purchased loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan. Interest on loans is recorded based on the principal amount outstanding. The accrual of
interest on impaired loans is discontinued when, in managements opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is
subsequently recognized only to the extent cash payments are received.



Allowance for Loan Losses



The provision for
loan losses is based upon managements estimate of the amount needed to maintain the allowance for loan losses at an adequate level. In making the evaluation of the adequacy of the allowance for loan losses, management gives consideration to
current economic conditions and trends, historical loan losses, concentration risks, statutory examinations of the loan portfolio by regulatory agencies, delinquency information and managements internal review of the loan portfolio. Loans are
considered impaired when it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due under the contractual terms of the loan. The measurement of impaired loans is generally based on the present
value of expected future cash flows discounted at the historical effective interest rate, or upon the fair value of the collateral if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, a
valuation allowance is established as a component of the allowance for loan losses. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially
from the assumptions used in making the evaluations. In addition, regulatory examiners may require the Company to recognize adjustments to the allowance for loan losses based on their judgments about information available to them at the time of
their examination.



Premises and Equipment



Premises and equipment are stated at cost less accumulated depreciation.
Land is carried at cost. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets or based on the lease terms for leasehold improvements. Estimated useful lives are 12 to 39 years for buildings and
leasehold improvements, 5 to 7 years for furniture, fixtures and equipment and 3 to 5 years for computers and related equipment. Repairs and maintenance costs are charged to operations as incurred and additions and improvements to premises and
equipment are capitalized. Upon sale or retirement, the cost and related accumulated depreciation are removed from the accounts and any gains or losses are reflected in current operations.



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



Stock in Federal Home Loan Bank of Atlanta



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



Foreclosed Real Estate and Repossessions



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



Income Taxes



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



Comprehensive Income



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



Stock Compensation Plans



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



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



Net Income Per Common Share and Common Shares Outstanding



Basic and diluted net income per share has been computed based on the
weighted average number of shares outstanding during each period after retroactively adjusting for a 5% stock dividend on June 30, 2006. In addition, all



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



components of stockholders equity presented on the consolidated balance sheets and the statements of changes in shareholders equity have been
retroactively restated for the effects of this stock dividend.



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



Basic and diluted net income per share have been computed
based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding after retroactively adjusting for the stock dividend as
summarized below:



|                                                                                                                             |  |           |  |           |  |          
|---------------------------------------------------------------------------------------------------------------------------- |  | --------- |  | --------- |  | ---------
|                                                                                                                             |  | 2006      |  | 2005      |  | 2004     
|Weighted average number of common shares used in computing basic net income per share                                        |  | 3,586,641 |  | 3,586,361 |  | 2,906,442
|Effect of dilutive stock options                                                                                             |  | 122,896   |  | 85,258    |  | 76,108   
|                                                                                                                             |  |           |  |           |  |          
|Weighted average number of common shares and dilutive potential common shares used in computing diluted net income per share |  | 3,709,537 |  | 3,671,619 |  | 2,982,550
|                                                                                                                             |  |           |  |           |  |          



For the years ended
December 31, 2006 and 2004, there were no options that were antidilutive. For the year ended December 31, 2005, there were 163,406 options that were antidilutive due to the exercise price exceeding the average market price for the period.



Recent Accounting Pronouncements



SAB 108In September 2006, the SEC issued Staff Accounting
Bulletin No.108 (SAB 108), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108, which is effective for years ending on or after November 15,
2006, was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements.



Traditionally, there have been two widely-recognized methods for quantifying the effects of financial statement misstatements: the roll-over
method and the iron curtain method. The roll-over method focuses primarily on the impact of a misstatement on the income statementincluding the reversing effect of prior year misstatementsbut its use can lead to the
accumulation of misstatements in the balance sheet. The iron curtain method focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior years errors on the income statement.
The Company previously used the roll-over method for quantifying identified financial statement misstatements.



SAB 108 establishes an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the
Companys financial statements and the related financial statement disclosures. This model is commonly referred to as a dual approach because it requires quantification of errors under both the iron curtain and the roll-over
methods.



SAB 108 permits public companies to initially apply
its provisions either by (i) restating prior financial statements as if the dual approach had always been applied or (ii) recording the cumulative effect of initially applying the dual approach as adjustments to the
carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to the opening balance of retained earnings.



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



The Company adopted SAB 108 during the quarter ended December 31, 2006
and elected to use the cumulative effect transition method in connection with the preparation of its financial statements. The following table summarizes the effects of applying the guidance in SAB 108:



|                                          |  |                                                 |      |   |                         |      |     |                                         |  |   |     |   |  |   |      |  
|----------------------------------------- |  | ----------------------------------------------- | ---- | - | ----------------------- | ---- | --- | --------------------------------------- |  | - | --- | - |  | - | ---- | -
|                                          |  | Period in which the misstatement originated (1) |      |   |                         |     
|                                          |  | Cumulativeprior
toJanuary 1, 2004               |      |   | Year ended December 31, |      |     | Adjustmentrecorded as ofJanuary 1, 2006 | 
|                                          |  |                                                 | 2004 |   |                         | 2005 |     |                                        
|                                          |  | (In thousands)                                  |     
|Accrued expenses and other liabilities(2) |  | $                                               | 204  |   |                         | $    | 30  |                                         |  | $ | 30  |   |  | $ | 264  |  
|Deferred income taxes(3)                  |  |                                                 | (78  | ) |                         |      | (12 | )                                       |  |   | (12 | ) |  |   | (102 | )
|                                          |  |                                                 |      |   |                         |      |     |                                         |  |   |     |   |  |   |      |  
|Impact on net income(4)                   |  | $                                               | 126  |   |                         | $    | 18  |                                         |  | $ | 18  |   |  |   |      |  
|                                          |  |                                                 |      |   |                         |      |     |                                         |  |   |     |   |  |   |      |  
|Retained earnings(5)                      |  |                                                 |      |   |                         |      |     |                                         |  |   |     |   |  | $ | 162  |  
|                                          |  |                                                 |      |   |                         |      |     |                                         |  |   |     |   |  |   |      |  

---

|(1) |  | The Company quantified these
errors under the roll-over method and concluded that they were immaterial both individually and in the aggregate.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | The Company was not recognizing
rent expense for one lease using the straight-line method. As a result of this error, its occupancy and equipment expense was understated by $204 thousand (cumulatively) in fiscal years ending prior to January 1, 2004, by $30 thousand in fiscal
year ending December 31, 2004 and by $30 thousand in fiscal year ending December 31, 2005.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | As a result of the lease
misstatement described, the Companys provision for income taxes was overstated $78 thousand (cumulatively) in fiscal years ending prior to January 1, 2004, by $12 thousand in fiscal year ending December 31, 2004 and by $12 thousand
in fiscal year ending December 31, 2005.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | Represents the net overstatement
of net income for the indicated periods resulting from these misstatements.
|--- |  | ------------------------------------------------------------------------------------------------------------

|(5) |  | Represents the net reduction to
retained earnings recorded as of January 1, 2006 to record the initial application of SAB 108.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------



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



SFAS 156, Accounting for Servicing of Financial Assetsan amendment of SFAS No. 140 requires that all separately recognized servicing assets and liabilities be initially measured at fair value
and permits (but does not require) subsequent measurement of servicing assets and liabilities at fair value. This statement is effective for fiscal years beginning after September 15, 2006. The Company has evaluated this statement and does not
believe the adoption of its provisions will have a material effect on the consolidated financial statements.



SFAS 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans requires recognition on the balance sheet of a
plans overfunded or underfunded status with an offset to comprehensive income. This statement also requires, with limited exceptions, that the funded status of the plan be determined as of the employers fiscal year end. The balance sheet
recognition provisions of SFAS 158 are effective for entities with publicly traded equity securities for years ending after December 15, 2006 and for all other entities for years ending after June 15, 2007. The Company has determined that
this statement has had no impact on the consolidated financial statements.



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



FIN 48In July 2006, the FASB issued Financial Interpretation
No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax
positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides
transition and interim period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for the Company in the first quarter of fiscal 2007. The Company does not
anticipate that the adoption of FIN 48 will have a material effect on its consolidated financial statements.



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



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



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



Reclassification



Certain items included in prior years consolidated financial statements have been reclassified to conform to the
current year presentation. The reclassifications had no effect on the net income or shareholders equity as previously reported.



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



NOTE CINVESTMENT SECURITIES



The following is a summary of the securities portfolio by major
classification at December 31, 2006 and 2005:



|                           |  |                |        |                      |   |                       |  |             |     |  |   |       
|-------------------------- |  | -------------- | ------ | -------------------- | - | --------------------- |  | ----------- | --- |  | - | ------
|                           |  | AmortizedCost  |        | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | MarketValue
|                           |  | (In thousands)
|December 31, 2006          |  |                |        |                      |   |                       |  |             |     |  |   |       
|U.S. government agencies   |  | $              | 10,008 |                      | $ | 3                     |  | $           | 97  |  | $ | 9,914 
|Municipals                 |  |                | 24,493 |                      |   | 65                    |  |             | 95  |  |   | 24,463
|Corporate bonds            |  |                | 529    |                      |   |                      |  |             | 4   |  |   | 525   
|Mortgage-backed securities |  |                | 35,077 |                      |   | 83                    |  |             | 497 |  |   | 34,663
|                           |  |                |        |                      |   |                       |  |             |     |  |   |       
|                           |  | $              | 70,107 |                      | $ | 151                   |  | $           | 693 |  | $ | 69,565
|                           |  |                |        |                      |   |                       |  |             |     |  |   |       
|                           |  |                |        |                     
|December 31, 2005          |  |                |        |                      |   |                       |  |             |     |  |   |       
|U.S. government agencies   |  | $              | 5,958  |                      | $ |                      |  | $           | 100 |  | $ | 5,858 
|Municipals                 |  |                | 17,285 |                      |   | 16                    |  |             | 153 |  |   | 17,148
|Corporate bonds            |  |                | 536    |                      |   |                      |  |             | 12  |  |   | 524   
|Mortgage-backed securities |  |                | 25,730 |                      |   |                      |  |             | 605 |  |   | 25,125
|                           |  |                |        |                      |   |                       |  |             |     |  |   |       
|                           |  | $              | 49,509 |                      | $ | 16                    |  | $           | 870 |  | $ | 48,655
|                           |  |                |        |                      |   |                       |  |             |     |  |   |       



The following tables
show gross unrealized losses and fair value of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005.



|                                      |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    
|------------------------------------- | ------------------- | ------------------- | ----------------- | ----------------- | --------- | --------- | ---------------- | ---------------- | --------- | --------- | ---------------- | ---------------- |  | - | ------ |  | - | ---
|                                      |                     | 2006               
|                                      | Less Than 12 Months |                     | 12 Months or More |                   | Total    
|                                      | FairValue           |                     | Unrealizedlosses  |                   | FairValue |           | Unrealizedlosses |                  | FairValue |           | Unrealizedlosses
|                                      | (In thousands)     
|Securities available for sale:        |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    
|U.S. government agencies              |                     | $                   | 1,944             |                   | $         | 11        |                  | $                | 5,178     |           | $                | 86               |  | $ | 7,122  |  | $ | 97 
|Municipals                            |                     |                     | 11,797            |                   |           | 63        |                  |                  | 2,987     |           |                  | 32               |  |   | 14,784 |  |   | 95 
|Corporate bonds                       |                     |                     | 525               |                   |           | 4         |                  |                  |          |           |                  |                 |  |   | 525    |  |   | 4  
|Mortgage-backed securities            |                     |                     | 4,855             |                   |           | 12        |                  |                  | 19,034    |           |                  | 485              |  |   | 23,889 |  |   | 497
|                                      |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    
|Total temporarily impaired securities |                     | $                   | 19,121            |                   | $         | 90        |                  | $                | 27,199    |           | $                | 603              |  | $ | 46,320 |  | $ | 693
|                                      |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    
|                                      |                    
|                                      |                     | 2005               
|                                      |                     | Less Than 12 Months |                   | 12 Months or More |           | Total    
|                                      |                     | FairValue           |                   | Unrealizedlosses  |           | FairValue |                  | Unrealizedlosses |           | FairValue |                  | Unrealizedlosses
|                                      | (In thousands)     
|Securities available for sale:        |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    
|U.S. government agencies              |                     | $                   | 2,466             |                   | $         | 34        |                  | $                | 2,433     |           | $                | 67               |  | $ | 4,899  |  | $ | 101
|Municipals                            |                     |                     | 12,576            |                   |           | 149       |                  |                  | 391       |           |                  | 4                |  |   | 12,967 |  |   | 153
|Corporate bonds                       |                     |                     | 524               |                   |           | 11        |                  |                  |          |           |                  |                 |  |   | 524    |  |   | 11 
|Mortgage-backed securities            |                     |                     | 14,410            |                   |           | 289       |                  |                  | 9,227     |           |                  | 316              |  |   | 23,637 |  |   | 605
|                                      |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    
|Total temporarily impaired securities |                     | $                   | 29,976            |                   | $         | 483       |                  | $                | 12,051    |           | $                | 387              |  | $ | 42,027 |  | $ | 870
|                                      |                     |                     |                   |                   |           |           |                  |                  |           |           |                  |                  |  |   |        |  |   |    



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



At December 31, 2006, temporarily impaired securities, 12 months or
more, consisted of eight U.S. government agency securities, six municipal securities and thirty-three mortgage-backed securities. None of the impaired securities have premiums associated with them. The Company believes the impairment relates to the
current interest rate environment and therefore, is not a permanent impairment, does not relate to the underlying credit quality of the issuers, and it has the intent and ability to hold these investments for a time necessary to recover their cost.
The remaining securities that have an unrealized loss have been impaired for less than 12 months, which includes three U.S. government agency securities, twenty municipal securities, one corporate bond, and seven mortgage-backed securities. The
Company believes the impairment relates to the current interest rate environment and there is not a permanent impairment. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates
since the securities were purchased. The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses relate to the
marketability of the securities or the issuers ability to honor redemption obligations, and considering that management has the intent and ability to hold these securities until maturity, none of the securities are deemed to be other than
temporarily impaired.



Securities with a carrying value of $6.1
million and $7.1 million at December 31, 2006 and 2005, respectively, were pledged to secure borrowings or deposits.



The amortized cost and fair values of securities available for sale at December 31, 2006 by contractual maturity are shown below. Actual expected
maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.



|                                       |                |               |        |           |   |       
|-------------------------------------- | -------------- | ------------- | ------ | --------- | - | ------
|                                       |                | AmortizedCost |        | FairValue
|                                       | (In thousands)
|Due in one year or less                |                | $             | 4,481  |           | $ | 4,423 
|Due after one year through five years  |                |               | 26,974 |           |   | 26,654
|Due after five years through ten years |                |               | 25,352 |           |   | 25,225
|Due after ten years                    |                |               | 13,300 |           |   | 13,263
|                                       |                |               |        |           |   |       
|                                       |                | $             | 70,107 |           | $ | 69,565
|                                       |                |               |        |           |   |       



Proceeds from
maturities, sales and calls of investment securities during the years ended December 31, 2006, 2005 and 2004 were $10.6 million, $9.1 million, and $8.2 million respectively. The Company realized gross gains of approximately $1 thousand,
$14 thousand, and $22 thousand in 2006, 2005, and 2004, respectively, and gross losses of approximately $61 thousand, $24 thousand, and $27 thousand in 2006, 2005, and 2004, respectively.



NOTE DLOANS



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



|                            |  |                |         |   |      |   |         |  
|--------------------------- |  | -------------- | ------- | - | ---- | - | ------- | -
|                            |  | 2006           |         |   | 2005 |  
|                            |  | (In thousands) |        
|Real estatemortgage        |  | $              | 286,703 |   |      | $ | 236,260 |  
|Home equity lines of credit |  |                | 30,726  |   |      |   | 24,286  |  
|Commercial and industrial   |  |                | 14,540  |   |      |   | 14,512  |  
|Consumer                    |  |                | 2,457   |   |      |   | 3,546   |  
|                            |  |                |         |   |      |   |         |  
|Subtotal                    |  |                | 334,426 |   |      |   | 278,604 |  
|Deferred loan fees, net     |  |                | (17     | ) |      |   | (218    | )
|                            |  |                |         |   |      |   |         |  
|Total                       |  | $              | 334,409 |   |      | $ | 278,386 |  
|                            |  |                |         |   |      |   |         |  



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



Loans are primarily made in southeastern North Carolina, principally New
Hanover, Pender and Brunswick Counties. Real estate loans can be affected by the condition of the local real estate market. Commercial and industrial loans can be affected by the local economic conditions.



Impaired loans consist of nonaccrual loans totaling approximately $350
thousand at December 31, 2006, $1.2 million at December 31, 2005, with $50 thousand and $160 thousand, respectively, of the allowance for loan losses allocated to such loans as of those dates. The average investment in impaired loans was
$3.5 million and $2.0 million for the years ended December 31, 2006 and 2005, respectively. Such loans had the effect of reducing interest income by approximately $113 thousand, $76 thousand, and $38 thousand during the years ended
December 31, 2006, 2005 and 2004, respectively.



An
analysis of the allowance for loan losses follows:



|                                |  |                |       |   |      |   |       |      |  |   |       |  
|------------------------------- |  | -------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|                                |  | 2006           |       |   | 2005 |   |       | 2004 | 
|                                |  | (In thousands) |      
|Balance at beginning of year    |  | $              | 3,510 |   |      | $ | 2,106 |      |  | $ | 1,661 |  
|Provision charged to operations |  |                | 1,340 |   |      |   | 1,499 |      |  |   | 892   |  
|                                |  |                |      
|Charge-offs:                    |  |                |       |   |      |   |       |      |  |   |       |  
|Home equity lines of credit     |  |                | (92   | ) |      |   | (43   | )    |  |   | (32   | )
|Real estate-mortgage            |  |                |      |   |      |   |      |      |  |   | (50   | )
|Consumer                        |  |                | (23   | ) |      |   | (10   | )    |  |   | (6    | )
|Commercial and industrial       |  |                | (292  | ) |      |   | (131  | )    |  |   | (415  | )
|                                |  |                |       |   |      |   |       |      |  |   |       |  
|Total charge-offs               |  |                | (407  | ) |      |   | (184  | )    |  |   | (503  | )
|                                |  |                |       |   |      |   |       |      |  |   |       |  
|Recoveries:                     |  |                |       |   |      |   |       |      |  |   |       |  
|Home equity lines of credit     |  |                |      |   |      |   | 74    |      |  |   |      |  
|Real estate-mortgage            |  |                | 4     |   |      |   | 4     |      |  |   | 11    |  
|Consumer                        |  |                | 5     |   |      |   | 1     |      |  |   | 3     |  
|Commercial and industrial       |  |                | 84    |   |      |   | 10    |      |  |   | 42    |  
|                                |  |                |       |   |      |   |       |      |  |   |       |  
|Total recoveries                |  |                | 93    |   |      |   | 89    |      |  |   | 56    |  
|                                |  |                |       |   |      |   |       |      |  |   |       |  
|Net charge-offs                 |  |                | (314  | ) |      |   | (95   | )    |  |   | (447  | )
|                                |  |                |       |   |      |   |       |      |  |   |       |  
|Balance at end of year          |  | $              | 4,536 |   |      | $ | 3,510 |      |  | $ | 2,106 |  
|                                |  |                |       |   |      |   |       |      |  |   |       |  



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



|                                                                |  |                |        |  
|--------------------------------------------------------------- |  | -------------- | ------ | -
|                                                                |  | (In thousands) |       
|Loans to directors and officers as a group at December 31, 2005 |  | $              | 5,263  |  
|Disbursements during year                                       |  |                | 3,457  |  
|Amounts collected during year                                   |  |                | (2,214 | )
|                                                                |  |                |        |  
|Loans to directors and officers as a group at December 31, 2006 |  | $              | 6,506  |  
|                                                                |  |                |        |  



At December 31,
2006, the Company had pre-approved but unused available credit totaling $471 thousand to directors, executive officers and their related interests.



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



NOTE EPREMISES AND EQUIPMENT



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



|                              |  |                |        |   |      |   |        |  
|----------------------------- |  | -------------- | ------ | - | ---- | - | ------ | -
|                              |  | 2006           |        |   | 2005 |  
|                              |  | (In thousands) |       
|Buildings                     |  | $              | 883    |   |      | $ | 833    |  
|Furniture and equipment       |  |                | 2,423  |   |      |   | 1,829  |  
|Leasehold improvements        |  |                | 1,041  |   |      |   | 345    |  
|Automobiles                   |  |                | 39     |   |      |   | 21     |  
|Construction in progress      |  |                | 38     |   |      |   | 231    |  
|                              |  |                |        |   |      |   |        |  
|                              |  |                | 4,424  |   |      |   | 3,259  |  
|Less accumulated depreciation |  |                | (1,470 | ) |      |   | (1,414 | )
|                              |  |                |        |   |      |   |        |  
|Total Premises and Equipment  |  | $              | 2,954  |   |      | $ | 1,845  |  
|                              |  |                |        |   |      |   |        |  



Depreciation and
amortization amounting to $410 thousand, $254 thousand, and $228 thousand for the years ended December 31, 2006, 2005, and 2004, respectively, is included in occupancy and equipment expense. Outstanding construction commitments at
December 31, 2006 were approximately $247 thousand.



NOTE
FDEPOSITS



Time deposits in denominations of $100
thousand or more were $131.0 million, and $96.0 million at December 31, 2006 and 2005, respectively. Interest expense on such deposits aggregated $5.7 million in 2006, $2.3 million in 2005, and $703 thousand in 2004.



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



|                                 |  |                   |         |                 |   |         |  |   |        
|-------------------------------- |  | ----------------- | ------- | --------------- | - | ------- |  | - | -------
|                                 |  | Less than$100,000 |         | $100,000or more |   | Total  
|                                 |  | (In thousands)   
|Three months or less             |  | $                 | 31,250  |                 | $ | 26,305  |  | $ | 57,555 
|Over three months to six months  |  |                   | 32,879  |                 |   | 27,253  |  |   | 60,132 
|Over six months to twelve months |  |                   | 56,664  |                 |   | 45,575  |  |   | 102,239
|Over twelve months               |  |                   | 16,255  |                 |   | 31,899  |  |   | 48,154 
|                                 |  |                   |         |                 |   |         |  |   |        
|Total                            |  | $                 | 137,048 |                 | $ | 131,032 |  | $ | 268,080
|                                 |  |                   |         |                 |   |         |  |   |        



NOTE GBORROWINGS



The Company may purchase federal funds through unsecured
federal funds lines of credit totaling $11.0 million. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and term of advances. These lines of credit are payable on demand and bear interest based
upon the daily federal funds rate. The Company had no amounts outstanding under these lines as of December 31, 2006 and 2005.



The Company has outstanding FHLB advances of $31 million and $22 million at December 31, 2006 and 2005, respectively. All of these advances at the
Federal Home Loan Bank of Atlanta are secured by a blanket lien on our qualifying 1-4 family first mortgages, commercial real estate loans, home equity lines of credit, and second mortgages in addition to investment securities totaling $5.0 million
currently pledged to FHLB. The Company has a maximum borrowing availability from FHLB of $63.7 million as of December 31, 2006. The maximum month end balances were $31 million and $28 million during the years ended December 31, 2006 and
2005.



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



The Company has a credit facility with the Federal Reserve Bank of Richmond,
secured by an investment security available for sale, under which the Company had a maximum borrowing availability of approximately $563 thousand at December 31, 2006. No amount was outstanding under this credit facility at December 31,
2006.



The Company has long-term debt of $10.3 million in
junior subordinated debentures payable to its subsidiary, BKWW Statutory Trust I. This debt was issued on October 4, 2005 and is callable in five years with a final maturity of October 4, 2035. The Trust was formed for the sole purpose of
issuing trust preferred securities and investing the proceeds from the sale of such trust preferred securities in junior subordinated debentures. The debentures held by the Trust are the sole assets of the Trust. The Company owns 100% of the
Trusts outstanding common securities and unconditionally guarantees the Trusts financial obligations. The debentures and the trust preferred securities bear a quarterly adjustable interest rate, currently 6.76%. The interest rate is
equal to 140 basis points over the three-month LIBOR (London Inter-Bank Offered Rate). The trust preferred securities generally rank equal to the trust common securities in priority of payment, but will rank prior to trust common securities if, and
so long as, the Company fails to make principal or interest payment on the debentures. Concurrently with the issuance of the debentures and the trust preferred securities, the Company entered into a Guaranty Agreement, dated October 4, 2005,
related to the trust preferred securities for the benefit of the holders. The debentures and trust preferred securities each have 30-year lives and will each be callable by the Company or the Trust, at their option, after five years. The Company has
the option to defer interest for up to five years on the debentures. The debentures qualify as Tier I capital under Federal Reserve Board guidelines.



Outstanding borrowings at December 31, 2006 and 2005 are presented below:



|                           |  |                      |   |  |                |        |      |   |       
|-------------------------- |  | -------------------- | - |  | -------------- | ------ | ---- | - | ------
|Maturity                   |  | CurrentInterest Rate |   |  | 2006           |        | 2005
|                           |  |                      |   |  | (In thousands)
|Short Term Borrowings      |  |                      |   |  |                |        |      |   |       
|Daily Rate Credit          |  | 5.51                 | % |  | $              | 3,000  |      | $ |      
|                           |  |                      |  
|Long Term Borrowings       |  |                      |   |  |                |        |      |   |       
|May 12, 2006               |  | 0.00                 | % |  |                |       |      |   | 5,000 
|April 27, 2007             |  | 4.15                 | % |  |                | 3,000  |      |   | 3,000 
|April 27, 2008             |  | 4.27                 | % |  |                | 3,000  |      |   | 3,000 
|May 12, 2008               |  | 5.52                 | % |  |                | 3,000  |      |   |      
|June 20, 2008              |  | 5.34                 | % |  |                | 5,000  |      |   |      
|April 27, 2009             |  | 4.48                 | % |  |                | 3,000  |      |   | 3,000 
|May 12, 2009               |  | 5.53                 | % |  |                | 3,000  |      |   |      
|August 25, 2015            |  | 4.10                 | % |  |                | 8,000  |      |   | 8,000 
|October 4, 2035            |  | 6.76                 | % |  |                | 10,310 |      |   | 10,310
|                           |  |                      |   |  |                |        |      |   |       
|Total Long Term Borrowings |  |                      |   |  |                | 38,310 |      |   | 32,310
|                           |  |                      |   |  |                |        |      |   |       
|Total Borrowings           |  |                      |   |  | $              | 41,310 |      | $ | 32,310
|                           |  |                      |   |  |                |        |      |   |       



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



NOTE HLEASES



The Company leases its main office, the land on which its Pine Valley branch is located, space in a shopping center for the
Hampstead office, the Surf City office, and the Waterford office, in addition to two office spaces behind its main office for the support services and credit administration departments, and has leased space for its new Oleander office opening in
2007, all under operating leases. These leases are for terms that range from three to fifteen years with renewal options up to thirty-five years. Future rental expense to be recognized under these leases are as follows:



|           |  |                |      
|---------- |  | -------------- | -----
|           |  | (In thousands)
|2007       |  | $              | 630  
|2008       |  |                | 494  
|2009       |  |                | 476  
|2010       |  |                | 478  
|2011       |  |                | 479  
|Thereafter |  |                | 2,775
|           |  |                |      
|           |  | $              | 5,332
|           |  |                |      



Rental expense for
operating leases was $483 thousand, $402 thousand, and $331 thousand during 2006, 2005 and 2004, respectively.



NOTE IINCOME TAXES



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



|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|-------------------------------------------------------------------------------------------- |  | -------------- | ----- | - | ---- | - | ----- | ---- |  | - | ---- | -
|                                                                                             |  | 2006           |       |   | 2005 |   |       | 2004 | 
|                                                                                             |  | (In thousands) |      
|Current tax provision                                                                        |  |                |       |   |      |   |       |      |  |   |      |  
|Federal                                                                                      |  | $              | 1,299 |   |      | $ | 925   |      |  | $ | 271  |  
|State                                                                                        |  |                | 365   |   |      |   | 214   |      |  |   | 53   |  
|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|Total current tax provision                                                                  |  |                | 1,664 |   |      |   | 1,139 |      |  |   | 324  |  
|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|Deferred tax provision (benefit)                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|Federal                                                                                      |  |                | (505  | ) |      |   | (292  | )    |  |   | 30   |  
|State                                                                                        |  |                | (108  | ) |      |   | (62   | )    |  |   | 2    |  
|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|Total deferred tax provision (benefit)                                                       |  |                | (613  | ) |      |   | (354  | )    |  |   | 32   |  
|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|Provision for income tax expense before adjustment to deferred tax asset valuation allowance |  |                | 1,051 |   |      |   | 785   |      |  |   | 356  |  
|Decrease in valuation allowance                                                              |  |                |      |   |      |   |      |      |  |   | (422 | )
|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  
|Net provision (benefit) for income taxes                                                     |  | $              | 1,051 |   |      | $ | 785   |      |  | $ | (66  | )
|                                                                                             |  |                |       |   |      |   |       |      |  |   |      |  



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



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



|                                              |  |                |       |   |      |   |     |      |  |   |      |  
|--------------------------------------------- |  | -------------- | ----- | - | ---- | - | --- | ---- |  | - | ---- | -
|                                              |  | 2006           |       |   | 2005 |   |     | 2004 | 
|                                              |  | (In thousands) |      
|Tax computed at the statutory federal rate    |  | $              | 1,130 |   |      | $ | 839 |      |  | $ | 368  |  
|Increase (decrease) resulting from:           |  |                |       |   |      |   |     |      |  |   |      |  
|State income taxes, net of federal tax effect |  |                | 169   |   |      |   | 100 |      |  |   | 36   |  
|Tax exempt interest                           |  |                | (220  | ) |      |   |    |      |  |   | (422 | )
|Stock based compensation                      |  |                | 40    |   |      |   |    |      |  |   |     |  
|Bank owned life insurance                     |  |                | (66   | ) |      |   | (68 | )    |  |   | (48  | )
|Other permanent differences                   |  |                | (2    | ) |      |   | (86 | )    |  |   |     |  
|                                              |  |                |       |   |      |   |     |      |  |   |      |  
|Provision (benefit) for income taxes          |  | $              | 1,051 |   |      | $ | 785 |      |  | $ | (66  | )
|                                              |  |                |       |   |      |   |     |      |  |   |      |  



Deferred income taxes
reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of deferred taxes at December 31,
2006 and 2005 are as follows:



|                                           |  |                |       |   |      |   |       |  
|------------------------------------------ |  | -------------- | ----- | - | ---- | - | ----- | -
|                                           |  | 2006           |       |   | 2005 |  
|                                           |  | (In thousands) |      
|Deferred tax assets relating to:           |  |                |       |   |      |   |       |  
|Allowance for loan losses                  |  | $              | 1,582 |   |      | $ | 1,210 |  
|Unrealized losses on investment securities |  |                | 209   |   |      |   | 329   |  
|Deferred Compensation                      |  |                | 228   |   |      |   |      |  
|Other                                      |  |                | 119   |   |      |   | 27    |  
|                                           |  |                |       |   |      |   |       |  
|Total deferred tax assets                  |  |                | 2,138 |   |      |   | 1,566 |  
|                                           |  |                |       |   |      |   |       |  
|                                           |  |               
|Deferred tax liabilities relating to:      |  |                |       |   |      |   |       |  
|Deferred loan costs                        |  |                | (330  | ) |      |   | (241  | )
|Prepaid expenses                           |  |                | (57   | ) |      |   | (41   | )
|Fixed asset differences                    |  |                | (98   | ) |      |   | (124  | )
|                                           |  |                |       |   |      |   |       |  
|                                           |  |                | (485  | ) |      |   | (406  | )
|                                           |  |                |       |   |      |   |       |  
|Net recorded deferred tax asset            |  | $              | 1,653 |   |      | $ | 1,160 |  
|                                           |  |                |       |   |      |   |       |  



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



NOTE JOTHER NON-INTEREST EXPENSE



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



|                                              |  |                |       |      |   |       |  |   |      
|--------------------------------------------- |  | -------------- | ----- | ---- | - | ----- |  | - | -----
|                                              |  | 2006           |       | 2005 |   | 2004 
|                                              |  | (In thousands)
|Advertising and promotion                     |  | $              | 549   |      | $ | 322   |  | $ | 246  
|Data processing and other outsourced services |  |                | 770   |      |   | 581   |  |   | 381  
|Postage, printing and office supplies         |  |                | 152   |      |   | 92    |  |   | 76   
|Professional services                         |  |                | 435   |      |   | 294   |  |   | 151  
|Other                                         |  |                | 936   |      |   | 677   |  |   | 413  
|                                              |  |                |       |      |   |       |  |   |      
|Total                                         |  | $              | 2,842 |      | $ | 1,966 |  | $ | 1,267
|                                              |  |                |       |      |   |       |  |   |      



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



NOTE KREGULATORY MATTERS



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



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



Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios, as prescribed by regulations, of total and Tier I capital to risk-weighted assets and of Tier I capital to average assets. As of April 19, 2006, the most recent
notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have
changed the Banks category. Management believes, as of December 31, 2006 and 2005, that all capital adequacy ratios place the Company and the Bank in excess of the minimum necessary to be deemed well capitalized under
regulatory guidelines. The Banks capital ratios are listed in the table below:



|                                                        |  |               |        |              |                     |   |                    |     |   |                       |      |  
|------------------------------------------------------- |  | ------------- | ------ | ------------ | ------------------- | - | ------------------ | --- | - | --------------------- | ---- | -
|                                                        |  | Actual        |        |              | MinimumRequirements |  
|                                                        |  | CapitalAmount |        | CapitalRatio |                     |   | ForCapitalAdequacy |     |   | To Be WellCapitalized |     
|                                                        |  | (Inthousands) |        |              |                     |   |                    |     |   |                       |     
|As of December 31, 2006                                 |  |               |        |              |                     |   |                    |     |   |                       |      |  
|Total capitalTier II capital (to risk-weighted assets) |  | $             | 40,689 |              | 11.5                | % |                    | 8.0 | % |                       | 10.0 | %
|Tier I capital (to risk-weighted assets)                |  |               | 36,265 |              | 10.3                | % |                    | 4.0 | % |                       | 6.0  | %
|Leverage Tier I capital (to average assets)             |  |               | 36,265 |              | 8.5                 | % |                    | 4.0 | % |                       | 5.0  | %
|As of December 31, 2005                                 |  |               |        |              |                     |   |                    |     |   |                       |      |  
|Total capitalTier II capital (to risk-weighted assets) |  | $             | 38,654 |              | 13.3                | % |                    | 8.0 | % |                       | 10.0 | %
|Tier I capital (to risk-weighted assets)                |  |               | 35,144 |              | 12.1                | % |                    | 4.0 | % |                       | 6.0  | %
|Leverage Tier I capital (to average assets)             |  |               | 35,144 |              | 10.7                | % |                    | 4.0 | % |                       | 5.0  | %



The Company is also
subject to these capital requirements. At December 31, 2006 and 2005, the Companys capital ratios are as follows:



|                                |  |                 |   |  |      |  
|------------------------------- |  | --------------- | - |  | ---- | -
|                                |  | At December 31, |  
|                                |  | 2006            |   |  | 2005 |  
|Total risk-based capital ratio  |  | 11.8            | % |  | 13.3 | %
|Tier 1 risk-based capital ratio |  | 10.1            | % |  | 12.1 | %
|Leverage ratio                  |  | 9.2             | % |  | 10.7 | %



40



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



NOTE LOFF-BALANCE SHEET RISK



The Company is a party to financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. These instruments involve, to varying
degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial
instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.



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



A summary of the contract amounts of the Companys exposure to off-balance sheet risk as of December 31, 2006 is as follows:



|                                                                    |  |   |             
|------------------------------------------------------------------- |  | - | ------------
|Financial instruments whose contract amounts represent credit risk: |  |   |             
|Commitments to extend credit                                        |  | $ | 23.3 million
|Undisbursed lines of credit                                         |  |   | 71.2 million
|Commercial and standby letters of credit                            |  |   | 1.2 million 



NOTE MDISCLOSURES ABOUT FAIR
VALUES OF FINANCIAL INSTRUMENTS



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



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



Cash and Due from Banks, Interest-Earning Deposits and Time Deposits in Other Banks



The carrying amounts for cash and due from banks,
interest-earning deposits, and time deposits in other banks approximate fair value because of the short maturities of those instruments.



Investment Securities



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



Loans



For certain homogenous categories of loans, such as
residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other



41



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar
credit ratings and for the same remaining maturities.



Accrued Interest
Receivable and Payable



The carrying amount is a
reasonable estimate of fair value.



Stock in Federal Home Loan Bank of
Atlanta



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



Bank Owned Life Insurance



The fair value of
Company owned life insurance is equivalent to the cash surrender value of the underlying policies.



Deposits



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



Borrowings



The fair value of borrowings is based upon discounting expected cash flows
using current rates at which borrowings of similar maturity could be obtained.



Financial Instruments with Off-Balance Sheet Risk



With regard to financial instruments with off-balance sheet risk discussed in Note L, it is not practicable to estimate the fair value of future financing commitments.



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



|                                         |  |                |         |                     |   |                |  |                     |         |  |   |        
|---------------------------------------- |  | -------------- | ------- | ------------------- | - | -------------- |  | ------------------- | ------- |  | - | -------
|                                         |  | 2006           |         | 2005               
|                                         |  | Carryingamount |         | Estimatedfair value |   | Carryingamount |  | Estimatedfair value
|                                         |  | (In thousands)
|Financial assets:                        |  |                |         |                     |   |                |  |                     |         |  |   |        
|Cash and due from banks                  |  | $              | 7,209   |                     | $ | 7,209          |  | $                   | 1,854   |  | $ | 1,854  
|Interest-earning deposits in other banks |  |                | 1,639   |                     |   | 1,639          |  |                     | 5,419   |  |   | 5,419  
|Investment securities                    |  |                | 69,565  |                     |   | 69,565         |  |                     | 48,655  |  |   | 48,655 
|Time deposits in other banks             |  |                | 298     |                     |   | 298            |  |                     | 199     |  |   | 199    
|Loans                                    |  |                | 329,873 |                     |   | 330,470        |  |                     | 274,876 |  |   | 273,727
|Accrued interest receivable              |  |                | 2,195   |                     |   | 2,195          |  |                     | 1,645   |  |   | 1,645  
|Stock in FHLB of Atlanta                 |  |                | 2,081   |                     |   | 2,081          |  |                     | 1,394   |  |   | 1,394  
|Bank owned life insurance                |  |                | 5,491   |                     |   | 5,491          |  |                     | 5,296   |  |   | 5,296  
|Financial liabilities:                   |  |                |         |                     |   |                |  |                     |         |  |   |        
|Deposits                                 |  |                | 353,617 |                     |   | 352,088        |  |                     | 284,134 |  |   | 282,055
|Borrowings                               |  |                | 41,310  |                     |   | 41,310         |  |                     | 32,310  |  |   | 32,310 
|Accrued interest payable                 |  |                | 745     |                     |   | 745            |  |                     | 457     |  |   | 457    



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



NOTE NEMPLOYEE AND DIRECTOR BENEFIT PLANS



401(K) Retirement Plan



The Company has adopted a 401(k) retirement plan that covers all eligible employees. The Company matched 100% of employee
contributions, with the Companys contribution limited to 6% of each employees salary for the years ended December 31, 2006, 2005 and 2004. Matching contributions are funded when accrued. Expenses under the plan totaled $160
thousand, $131 thousand and $102 thousand for the years ended December 31, 2006, 2005 and 2004, respectively.



Stock Option Plans



The Company has two share-based compensation plans in effect at December 31, 2006. The compensation cost that has been charged against income for
those plans was approximately $118 thousand for 2006 and none for 2005 and 2004. There has been no deferred tax assets recorded due to the fact that stock based compensation expense results solely from incentive stock options.



During 1999 the Company adopted, with shareholder approval, an Employee Stock
Option Plan (the Employee Plan) and a Director Stock Option Plan (the Director Plan). Each plan was amended as of June 17, 2005 with shareholder approval to increase the number of shares available for options to purchase
shares of the Companys common stock. As of December 31, 2006, the Employee Plan made available options to purchase 358,705 shares of the Companys common stock and the Director Plan made available options to purchase 215,222 shares
of the Companys common stock, for an aggregate number of common shares reserved for options of 573,927. Options of 167,672 granted under the Director Plan vested immediately at the time of grant and 41,344 granted under the Director Plan
vested after six months, while the options granted under the Employee Plan vest over a five-year period for 166,048 options, over a four-year period for 36,094 options, and over a three-year period for 85,968 options. All unexercised options expire
ten years after the date of grant. Options under these plans must be granted at a price not less than the fair market value at the date of the grant.



The fair market value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. The risk-free interest rate is
based upon a U.S. Treasury instrument with a life that is similar to the expected life of the option grant. Expected volatility is based upon the historical volatility of the Company based upon the previous three years trading history. The expected
term of the options is based upon the average life of previously issued stock options. The expected dividend yield is based upon current yield on date of grant. No post-vesting restrictions exist for these options. No options were granted during
2006, 163,406 options were granted during 2005, and no options were granted in 2004. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions
used for grants in 2005: dividend yield of 0.00 percent; expected volatility of 14.29 percent; risk-free interest rate of 4.50 percent; and expected life of 7 years. The weighted-average grant date fair value of options granted in 2005 was $3.14.



43



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



A summary of the Companys option plans as of and for the periods ended
December 31, 2006, 2005, and 2004 is as follows:



|                        |  |                                 |   |  |                              |   |                     |   |       |                              |         |   |  |   |      
|----------------------- |  | ------------------------------- | - |  | ---------------------------- | - | ------------------- | - | ----- | ---------------------------- | ------- | - |  | - | -----
|                        |  | SharesAvailablefor FutureGrants |   |  | Outstanding Options          |   | Exercisable Options
|                        |  | NumberOutstanding               |   |  | WeightedAverageExercisePrice |   | NumberOutstanding   |   |       | WeightedAverageExercisePrice
|At December 31, 2003    |  | 16,940                          |   |  | 263,958                      |   |                     | $ | 6.10  |                              | 242,373 |   |  | $ | 6.06 
|Options granted/vesting |  |                                |   |  |                             |   |                     |   |      |                              | 20,168  |   |  |   | 6.82 
|Options exercised       |  |                                |   |  | (788                         | ) |                     |   | 3.97  |                              | (788    | ) |  |   | 3.97 
|Options forfeited       |  |                                |   |  |                             |   |                     |   |      |                              |        |   |  |   |     
|                        |  |                                 |   |  |                              |   |                     |   |       |                              |         |   |  |   |      
|At December 31, 2004    |  | 16,940                          |   |  | 263,170                      |   |                     |   | 6.10  |                              | 261,753 |   |  |   | 6.11 
|Plan amendment          |  | 292,871                         |   |  |                             |   |                     |   |      |                              |        |   |  |   |     
|Options granted/vesting |  | (163,406                        | ) |  | 163,406                      |   |                     |   | 10.25 |                              | 1,312   |   |  |   | 3.97 
|Options exercised       |  |                                |   |  | (11,746                      | ) |                     |   | 6.94  |                              | (11,746 | ) |  |   | 6.94 
|Options forfeited       |  | 262                             |   |  | (262                         | ) |                     |   | 3.97  |                              | (262    | ) |  |   | 3.97 
|                        |  |                                 |   |  |                              |   |                     |   |       |                              |         |   |  |   |      
|At December 31, 2005    |  | 146,667                         |   |  | 414,568                      |   |                     |   | 7.71  |                              | 251,057 |   |  |   | 6.07 
|Options granted/vesting |  |                                |   |  |                             |   |                     |   |      |                              | 79,129  |   |  |   | 10.25
|Options exercised       |  |                                |   |  | (262                         | ) |                     |   | 3.97  |                              | (262    | ) |  |   | 3.97 
|Options forfeited       |  | 1                               |   |  | (1                           | ) |                     |   | 3.97  |                              | (1      | ) |  |   | 3.97 
|                        |  |                                 |   |  |                              |   |                     |   |       |                              |         |   |  |   |      
|At December 31, 2006    |  | 146,668                         |   |  | 414,305                      |   |                     | $ | 7.72  |                              | 329,923 |   |  | $ | 7.07 
|                        |  |                                 |   |  |                              |   |                     |   |       |                              |         |   |  |   |      



A summary of option
activity and changes under the stock option plans during the year ended December 31, 2006 is presented below:



|                                  |  |                                                 |   |  |                               |      |                                         |            |                         |   |      
|--------------------------------- |  | ----------------------------------------------- | - |  | ----------------------------- | ---- | --------------------------------------- | ---------- | ----------------------- | - | -----
|                                  |  | Shares                                          |   |  | WeightedAverageExercise Price |      | WeightedAverageRemainingContractualTerm |            | AggregateIntrinsicValue
|                                  |  | (In thousands, except share and per share data)
|Outstanding at December 31, 2005  |  | 414,568                                         |   |  | $                             | 7.71 |                                         |            |                         |   |      
|Exercised                         |  | (262                                            | ) |  |                               | 3.97 |                                         |            |                         |   |      
|Forfeited                         |  | (1                                              | ) |  |                               | 3.97 |                                         |            |                         |   |      
|Granted                           |  |                                                |   |  |                               |     |                                         |            |                         |   |      
|                                  |  |                                                 |   |  |                               |      |                                         |            |                         |   |      
|Outstanding at December 31, 2006  |  | 414,305                                         |   |  | $                             | 7.72 |                                         | 5.37 years |                         | $ | 1,400
|                                  |  |                                                 |   |  |                               |      |                                         |            |                         |   |      
|Exerciseable at December 31, 2006 |  | 329,923                                         |   |  | $                             | 7.07 |                                         | 4.56 years |                         | $ | 1,330
|                                  |  |                                                 |   |  |                               |      |                                         |            |                         |   |      



There were 262,
11,746, and 788 options exercised during the years ended December 31, 2006, 2005, and 2004, respectively. There was $1 thousand, $82 thousand, and $9 thousand of proceeds recorded from the exercise of these options in December 31, 2006,
2005 and 2004, respectively. There was a one-half fractional share (rounded to one share) forfeited in connection with the exercise of the shares in 2006, 262 shares forfeited in 2005 and none in 2004. The intrinsic value of options exercised for
the years ended December 31, 2006, 2005 and 2004 was approximately $2 thousand, $46 thousand, and $6 thousand, respectively.



44



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



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



|                             |  |                                       |   |  |                                      |     
|---------------------------- |  | ------------------------------------- | - |  | ------------------------------------ | ----
|                             |  | Shares                                |   |  | WeightedAverage GrantDate Fair Value
|                             |  | (In thousands, except per share data)
|Non-vestedDecember 31, 2005 |  | 163,511                               |   |  | $                                    | 3.14
|Granted                      |  |                                      |   |  |                                      |    
|Vested                       |  | (79,129                               | ) |  |                                      | 3.14
|Forfeited                    |  |                                      |   |  |                                      |    
|                             |  |                                       |   |  |                                      |     
|Non-vestedDecember 31, 2006 |  | 84,382                                |   |  | $                                    | 3.14
|                             |  |                                       |   |  |                                      |     



There were 79,129,
1,312, and 20,168 stock options vested during the years ended December 31, 2006, 2005, and 2004, respectively. The fair value of stock options vested during the years ended December 31, 2006, 2005, and 2004 were $249 thousand, $0, and $58
thousand, respectively.



As of December 31, 2006, there
was $212 thousand of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under all of the Companys stock benefit plans. That cost is expected to be recognized over a weighted-average period
of 1.86 years.



The Company funds the option shares from
authorized but unissued shares. The Company does not typically purchase shares to fulfill the obligations of the stock benefit plans. The option plan requires option holders to exercise options with payment in cash.



The adoption of SFAS 123R and its fair value compensation cost recognition
provisions are different from the non-recognition provisions under SFAS 123 and the intrinsic value method for compensation cost allowed under APB 25. The effect (increase/(decrease)) of the adoption of SFAS 123R is as follows (in thousands, except
per share data):



|                                           |  |                             |       |  
|------------------------------------------ |  | --------------------------- | ----- | -
|                                           |  | Year EndedDecember 31, 2006 |      
|                                           |  | (In thousands)              |      
|Income before income tax expense           |  | $                           | (118  | )
|Net income                                 |  | $                           | (118  | )
|                                           | 
|Cash flow from operating activities        |  | $                           | 118   |  
|Cash flow provided by financing activities |  | $                           |      |  
|                                           | 
|Basic earnings per share                   |  | $                           | (0.03 | )
|Diluted earnings per share                 |  | $                           | (0.03 | )



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



The following illustrates the effect on net income available to common
stockholders if the Company had applied the fair value recognition provisions of SFAS No. 123 to the prior years ended December 31, 2005 and 2004:



|                                                                                                                                      |  |                                     |       |   |      |   |       |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------------------- | ----- | - | ---- | - | ----- | -
|                                                                                                                                      |  | 2005                                |       |   | 2004 |  
|                                                                                                                                      |  | (In thousands,except per sharedata) |      
|Net income:                                                                                                                           |  |                                     |       |   |      |   |       |  
|As reported                                                                                                                           |  | $                                   | 1,682 |   |      | $ | 1,148 |  
|Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax
effects |  |                                     | (125  | ) |      |   | (48   | )
|                                                                                                                                      |  |                                     |       |   |      |   |       |  
|                                                                                                                                      |  | $                                   | 1,557 |   |      | $ | 1,100 |  
|                                                                                                                                      |  |                                     |       |   |      |   |       |  
|Pro forma                                                                                                                             |  |                                     |       |   |      |   |       |  
|                                                                                                                                      |  |                                    
|Basic net income per share:                                                                                                           |  |                                     |       |   |      |   |       |  
|As reported                                                                                                                           |  | $                                   | 0.47  |   |      | $ | 0.39  |  
|Pro forma                                                                                                                             |  |                                     | 0.43  |   |      |   | 0.38  |  
|Diluted net income per share:                                                                                                         |  |                                     |       |   |      |   |       |  
|As reported                                                                                                                           |  | $                                   | 0.46  |   |      | $ | 0.38  |  
|Pro forma                                                                                                                             |  |                                     | 0.42  |   |      |   | 0.37  |  



Employment Agreement



The Company has entered into an employment agreement with
its Chief Executive Officer. The agreement provides for a three-year term but, upon each anniversary, the agreement may be extended for an additional year so that the remaining term shall always be three years. The agreement provides for benefits as
spelled out in the contract and cannot be terminated by the Board of Directors, except for cause, without prejudicing the officers right to receive certain vested rights, including compensation, for the remaining term of the agreement. In the
event of a change in control of the Company, as defined in the agreement, the agreement will automatically be extended for three years from the date of such change in control and the acquirer will be bound to the terms of the contract for that
period.



Termination Agreements



The Company has entered into special termination agreements with six key
employees which provide for severance pay benefits in the event of a change in control of the Company which results in the termination of such employees or diminished compensation, duties or benefits within two years of a change in control. The
employees covered under this agreement are entitled to a cash payment equal to two times their annual compensation for three employees and one and a half times their annual compensation for the other three employees, for income tax purposes for the
most recent tax year prior to the change in control. The agreements are initially effective for a three-year period and are automatically extended annually for an additional year unless the Companys Board of Directors takes specific action not
to grant the automatic extension.



Supplemental Employee Retirement Plan and
Endorsement Split Dollar Plans



In 2005, the Company
implemented a non-qualifying deferred compensation plan for four key executive officers. The Company purchased life insurance policies on these four key executive officers and certain other key officers during 2004 in order to provide future funding
of benefit payments. The Company has agreed to share with the officers designated beneficiaries a portion of the total death benefits payable under the policies following their deaths. The insurance policies are owned by the Company and the
Company is entitled to receive all death benefits remaining after payment to the officers beneficiary. The Company expects to recover in full its life insurance investment.



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CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



Benefits for each executive officer participating in the deferred
compensation plan will accrue and vest during the period of employment, and will be paid in monthly benefit payments over the participants life after retirement. The plan also provides for payment of disability or death benefits in the event a
participating officer becomes permanently disabled or dies prior to attainment of retirement age. If the Company has a change in control before the officer reaches retirement age, the participating officer will be entitled to a benefit. Provisions
of approximately $298 thousand and $211 thousand were expensed for future benefits to be provided under this plan for the years ended December 31, 2006 and 2005, respectively. The total liability under this plan was approximately $509 thousand
and $211 thousand at December 31, 2006 and 2005, respectively, and is included in accrued expenses and other liabilities in the accompanying consolidated balance sheets.



Director Elective Income Deferral Agreements and Split Dollar Plans for Directors



In 2005, the Company entered into Director Elective Income Deferral
Agreements with each non-employee director. Interest on the amount deferred is credited by the Bank on the last business day of that year at a rate equal to the prime rate reported in the Wall Street Journal on that day, plus fifty basis
points. The interest crediting rate for 2006 was 8.75%. Total deferred fees and credited interest will be paid to the director either in a lump sum or in installments over 120 months from retirement on or after reaching the normal retirement age of
65. The expense incurred by the Company for these agreements were approximately $50 thousand and $37 thousand for the year ended December 31, 2006 and 2005, respectively. The total liability under these agreements was approximately $87 thousand
and $37 thousand at December 31, 2006 and 2005, respectively, and is included in accrued expenses and other liabilities in the accompanying consolidated balance sheets.



In order to fund the benefits payable under the Director Elective Income Deferral Agreements, the Company has purchased life
insurance policies on each director. The policies are designed to offset the programs costs during the lifetime of the participant and to provide complete recovery of all the programs costs at their death. The Company has agreed to share
with the directors designated beneficiaries a portion of the total death benefits payable under the policies following their deaths. The insurance policies are owned by the Company and the Company is entitled to receive all death benefits
remaining after payment to the directors beneficiary. The Company expects to recover, in full, its life insurance investment.



NOTE OPARENT COMPANY FINANCIAL INFORMATION



Condensed financial information of Cape Fear Bank Corporation, the parent company, at December 31, 2006 and 2005 are presented below. Cape Fear Bank
Corporation was incorporated on June 20, 2005; therefore, financial information is presented only for the years 2006 and 2005.



CONDENSED BALANCE SHEET



|                                           |  |                |        |      |   |       
|------------------------------------------ |  | -------------- | ------ | ---- | - | ------
|                                           |  | 2006           |        | 2005
|                                           |  | (In thousands)
|ASSETS:                                    |  |                |        |      |   |       
|Cash                                       |  | $              | 884    |      | $ |      
|Equity investment in subsidiaries          |  |                | 36,243 |      |   | 34,929
|Other assets                               |  |                | 312    |      |   | 91    
|                                           |  |                |        |      |   |       
|TOTAL ASSETS                               |  | $              | 37,439 |      | $ | 35,020
|                                           |  |                |        |      |   |       
|LIABILITIES AND SHAREHOLDERS EQUITY:      |  |                |        |      |   |       
|Junior subordinated debt                   |  | $              | 10,310 |      | $ | 10,310
|Other liabilities                          |  |                | 77     |      |   | 75    
|Shareholders equity                       |  |                | 27,052 |      |   | 24,635
|                                           |  |                |        |      |   |       
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY |  | $              | 37,439 |      | $ | 35,020
|                                           |  |                |        |      |   |       



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##### Table of Contents

CAPE FEAR BANK CORPORATION AND SUBSIDIARY



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2006, 2005 and 2004



|                                                 |  |                |       |   |      |   |     |  
|------------------------------------------------ |  | -------------- | ----- | - | ---- | - | --- | -
|CONDENSED STATEMENT OF OPERATIONS                | 
|                                                 |  |               
|                                                 |  | 2006           |       |   | 2005 |  
|                                                 |  | (In thousands) |      
|Dividends from subsidiary                        |  | $              | 1,668 |   |      | $ | 116 |  
|Equity in undistributed net income of subsidiary |  |                | 1,166 |   |      |   | 620 |  
|Miscellaneous expenses                           |  |                | (562  | ) |      |   | (99 | )
|                                                 |  |                |       |   |      |   |     |  
|NET INCOME                                       |  | $              | 2,272 |   |      | $ | 637 |  
|                                                 |  |                |       |   |      |   |     |  



CONDENSED STATEMENT
OF CASH FLOWS



|                                                 |  |                |        |   |      |   |         |  
|------------------------------------------------ |  | -------------- | ------ | - | ---- | - | ------- | -
|                                                 | 
|                                                 |  | 2006           |        |   | 2005 |  
|                                                 |  | (In thousands) |       
|CASH FLOWS FROM OPERATING ACTIVITIES:            |  |                |        |   |      |   |         |  
|Net income                                       |  | $              | 2,272  |   |      | $ | 637     |  
|Equity in undistributed net income of subsidiary |  |                | (1,166 | ) |      |   | (620    | )
|Change in other assets                           |  |                | (221   | ) |      |   | (91     | )
|Change in other liabilities                      |  |                | 3      |   |      |   | 75      |  
|                                                 |  |                |        |   |      |   |         |  
|NET CASH PROVIDED BY OPERATING ACTIVITIES        |  |                | 888    |   |      |   | 1       |  
|                                                 |  |                |        |   |      |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES             |  |                |        |   |      |   |         |  
|Investment in Trust                              |  |                |       |   |      |   | (311    | )
|Investment in Bank                               |  |                |       |   |      |   | (10,000 | )
|                                                 |  |                |        |   |      |   |         |  
|NET CASH USED BY INVESTING ACTIVITIES            |  |                |       |   |      |   | (10,311 | )
|                                                 |  |                |        |   |      |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES             |  |                |        |   |      |   |         |  
|Proceeds from issuance of common stock, net      |  |                | (4     | ) |      |   |        |  
|Proceeds from long-term borrowings               |  |                |       |   |      |   | 10,310  |  
|                                                 |  |                |        |   |      |   |         |  
|NET CASH PROVIDED BY FINANCING ACTIVITIES        |  |                | (4     | ) |      |   | 10,310  |  
|                                                 |  |                |        |   |      |   |         |  
|NET INCREASE IN CASH AND CASH EQUIVALENTS        |  |                | 884    |   |      |   |        |  
|CASH AND CASH EQUIVALENTS, BEGINNING             |  |                |       |   |      |   |        |  
|                                                 |  |                |        |   |      |   |         |  
|CASH AND CASH EQUIVALENTS, ENDING                |  | $              | 884    |   |      | $ |        |  
|                                                 |  |                |        |   |      |   |         |  



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##### Table of Contents

CAPE FEAR BANK CORPORATION

Management and Bank Personnel

---



DIRECTORS



Cameron Coburn

President and Chief Executive Officer of Cape Fear Bank Corporation



W. Lee Crouch, Jr.

Realtor/Broker of
Intracoastal Realty Corporation



Windell Daniels

President of United National Tours; Real Estate Developer



Craig S. Relan

Private Investor



Jerry D. Sellers

Partner, Sellers Tile Co., Inc.



J. Davie Waggett

Owner, Winter Park Discount Drugs and Seashore Discount Drugs



Walter O. Winter

Real Estate Investor



EXECUTIVE OFFICERS



Cameron Coburn

President and Chief Executive Officer



Betty V. Norris

Senior Vice President/Treasurer and Chief Financial Officer



R. James MacLaren

Senior Vice President and Chief Credit Officer



Lynn M. Burney

Senior Vice President and Chief Operations Officer



A.
Mark Tyler

Senior Vice President and Chief Banking Officer



Michelle L. Southerland

Vice President and Corporate Secretary



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CAPE FEAR BANK CORPORATION

General Corporate Information

---



Cape Fear Bank Office Locations



|                          |  |                                  
|------------------------- |  | ---------------------------------
|Main Office               |  | Pine Valley Branch Office        
|1117 Military Cutoff Road |  | 3702 South College Road          
|Wilmington, NC 28405      |  | Wilmington, NC 28412             
|                          | 
|Surf City Branch Office   |  | Hampstead Branch Office          
|13500 Highway 50          |  | Hampstead Station Shopping Center
|Suite 101                 |  | Unit 1-A                         
|Surf City, NC 28445       |  | 14572 US Highway 17              
|                          |  | Hampstead, NC 28443              



Waterford Branch
Office

503 Olde Waterford Way

Suite 104

Leland, NC 28451



Market for Common Stock



Cape Fear Bank Corporations common stock is listed for trading on The Nasdaq Capital Market under the symbol CAPE. As of December 31, 2006, there were
3,586,780 shares of common stock outstanding which were held by approximately 782 shareholders of record.



|                                          |  |  |  |                                                                                        |  |   |       |  |   |       |  | 
|----------------------------------------- |  |  |  | -------------------------------------------------------------------------------------- |  | - | ----- |  | - | ----- |  | 
|Stock Transfer Agent                      |  |  |  |                                                                                        |  |   |       |  |   |       |  | 
|                                          |  |  |  |                                                                                        |  |   |       |  |   |       |  | 
|Registrar and Transfer Company            |  |  |  |                                                                                        |  |   |       |  |   |       |  | 
|10 Commerce Drive Cranford, NJ 07016-3572 |  |  |  | The table below presents the trading prices for the Companys stock for 2006 and 2005: |  |  
|                                          |  |  |  |                                                                                        |  |   |       |  |   |       |  | 
|Regulatory and Securities Counsel         |  |  |  |                                                                                        |  |   | High  |  |   | Low   |  | 
|                                          |  |  |  | 2006                                                                                   |  |   |       |  |   |       |  | 
|Ward and Smith, PA                        |  |  |  | Fourth quarter                                                                         |  | $ | 12.85 |  | $ | 11.10 |  | 
|Post Office Box 867                       |  |  |  | Third quarter                                                                          |  | $ | 12.99 |  | $ | 12.10 |  | 
|New Bern, NC 28563-0867                   |  |  |  | Second quarter                                                                         |  | $ | 13.05 |  | $ | 11.33 |  | 
|                                          |  |  |  | First quarter                                                                          |  | $ | 11.70 |  | $ | 10.19 |  | 
|Independent Auditors                      |  |  |  | 2005                                                                                   |  |   |       |  |   |       |  | 
|                                          |  |  |  | Fourth quarter                                                                         |  | $ | 10.33 |  | $ | 9.52  |  | 
|Dixon Hughes PLLC                         |  |  |  | Third quarter                                                                          |  | $ | 10.43 |  | $ | 9.20  |  | 
|1003 Red Banks Road                       |  |  |  | Second quarter                                                                         |  | $ | 10.22 |  | $ | 8.00  |  | 
|Greenville, NC 27858                      |  |  |  | First quarter                                                                          |  | $ | 9.01  |  | $ | 8.57  |  | 
|                                          |  |  |  |                                                                                        |  |   |       |  |   |       |  | 



50



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##### Table of Contents

CAPE FEAR BANK CORPORATION

General Corporate Information

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Performance Graph



The following line graphs compare the cumulative total shareholder return (the CTSR) on our common stock during the previous five years with the CTSR over the same measurement period of the Nasdaq
Composite and the SNL Bank and Thrift Index. Each line graph assumes that $100 was invested on December 31, 2001, and that dividends were reinvested in additional shares.



LOGO



|                           |  |               |  |          |  |          |  |          |  |          |  |         
|-------------------------- |  | ------------- |  | -------- |  | -------- |  | -------- |  | -------- |  | --------
|                           |  | Period Ending
|Index                      |  | 12/31/01      |  | 12/31/02 |  | 12/31/03 |  | 12/31/04 |  | 12/31/05 |  | 12/31/06
|Cape Fear Bank Corporation |  | 100.00        |  | 125.00   |  | 220.37   |  | 209.07   |  | 251.16   |  | 269.79  
|NASDAQ Composite           |  | 100.00        |  | 68.76    |  | 103.67   |  | 113.16   |  | 115.57   |  | 127.58  
|SNL Bank and Thrift        |  | 100.00        |  | 93.96    |  | 127.39   |  | 142.66   |  | 144.89   |  | 169.30  



Annual Report on
Form 10-K



A copy of Cape Fear Bank Corporations 2006 Annual
Report on Form 10-K, as filed with the Securities and Exchange Commission, is available without charge to shareholders upon written request to Betty V. Norris, Senior Vice President/Treasurer, Cape Fear Bank Corporation, 1117 Military Cutoff Road,
Wilmington, NC 28405.



This Annual Report serves as the annual
financial disclosure statement furnished pursuant to the Federal Deposit Insurance Corporations rules and regulations. This statement has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance
Corporation.



51