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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549



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FORM 10-QSB



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QUARTERLY REPORT UNDER SECTION 13 OR
15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934



For the quarterly period ended September 30, 2004



Commission File No: 0-24479



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AF Financial Group

(Exact name of small business issuer as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Federally Chartered                                            |  | 56-2098545                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



21 East Ashe Street

West Jefferson, North Carolina 28694

(Address of principal executive offices)



(336) 246-4344

(Issuers telephone number)



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



As
of October 31, 2004 there were 1,049,835 shares of the registrants common stock outstanding, $.01 par value.



Transitional Small Business Disclosure Format:    Yes ̈No  x



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##### Table of Contents

AF FINANCIAL GROUP



CONTENTS



|                                                                                                                                        |  |       
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ------
|                                                                                                                                        |  | Pages 
|PART I - FINANCIAL INFORMATION                                                                                                          |  |       
|                                                                                                                                        | 
|Item 1. Financial Statements                                                                                                            |  | 1     
|                                                                                                                                        | 
|Condensed Consolidated Statements of Financial Condition as of September 30, 2004 (unaudited) and June 30, 2004                         |  |       
|                                                                                                                                        | 
|Condensed Consolidated Statements of Income and Comprehensive Income (unaudited) for the Three Months ended September 30, 2004 and 2003 |  | 2     
|                                                                                                                                        | 
|Condensed Consolidated Statements of Cash Flows (unaudited) for the Three Months ended September 30, 2004 and 2003                      |  | 3     
|                                                                                                                                        | 
|Notes to Condensed Consolidated Financial Statements                                                                                    |  | 4  7 
|                                                                                                                                        | 
|Item 2.
Managements Discussion and Analysis                                                                                            |  | 8  16
|Item 3.
Controls and Procedures                                                                                                         |  | 16    
|                                                                                                                                        | 
|PART II 
OTHER INFORMATION                                                                                                             |  |       
|                                                                                                                                        | 
|Item 1.
Legal Proceedings                                                                                                               |  | 17    
|Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds                                                                     |  | 17    
|Item 3.
Defaults Upon Senior Securities                                                                                                 |  | 17    
|Item 4.
Submission of Matters to a Vote of Security Holders                                                                             |  | 17    
|Item 5.
Other Information                                                                                                               |  | 17    
|Item 6.
Exhibits                                                                                                                        |  | 17    
|Signatures                                                                                                                              |  | 18    



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AF FINANCIAL GROUP AND SUBSIDIARIES



CONDENSED
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

As of September 30, 2004 and June 30, 2004



ASSETS



|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ----------- | - | ------------- | - | ----------- | -
|                                                                                                                                                               |  | September 30,2004 |             |   | June 30, 2004 |  
|                                                                                                                                                               |  | (Unaudited)       |             |   | (*)           |  
|Cash and cash equivalents:                                                                                                                                     |  |                   |             |   |               |   |             |  
|Interest-bearing deposits                                                                                                                                      |  | $                 | 2,486,641   |   |               | $ | 2,498,878   |  
|Noninterest-bearing deposits                                                                                                                                   |  |                   | 6,062,824   |   |               |   | 5,175,174   |  
|Securities held to maturity                                                                                                                                    |  |                   | 524,000     |   |               |   | 529,000     |  
|Securities available for sale                                                                                                                                  |  |                   | 3,688,232   |   |               |   | 4,315,066   |  
|Federal Home Loan Bank stock                                                                                                                                   |  |                   | 2,107,200   |   |               |   | 1,657,200   |  
|                                                                                                                                                               |  |                  
|Loans                                                                                                                                                          |  |                   | 190,671,934 |   |               |   | 182,734,177 |  
|Less allowance for loan losses                                                                                                                                 |  |                   | (1,304,473  | ) |               |   | (1,245,018  | )
|                                                                                                                                                               |  |                  
|Loans receivable, net                                                                                                                                          |  |                   | 189,367,461 |   |               |   | 181,489,159 |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|Office properties and equipment, net                                                                                                                           |  |                   | 12,483,935  |   |               |   | 11,515,179  |  
|Accrued interest receivable on loans                                                                                                                           |  |                   | 948,466     |   |               |   | 855,408     |  
|Accrued interest receivable on investment securities                                                                                                           |  |                   | 45,494      |   |               |   | 66,402      |  
|Prepaid expenses and other assets                                                                                                                              |  |                   | 1,799,151   |   |               |   | 1,560,688   |  
|Deferred income taxes, net                                                                                                                                     |  |                   | 262,450     |   |               |   | 280,577     |  
|Goodwill                                                                                                                                                       |  |                   | 1,676,446   |   |               |   | 1,676,446   |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|Total assets                                                                                                                                                   |  | $                 | 221,452,300 |   |               | $ | 211,619,177 |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                           |  |                   |             |   |               |   |             |  
|Liabilities:                                                                                                                                                   |  |                   |             |   |               |   |             |  
|Savings deposits                                                                                                                                               |  | $                 | 157,965,544 |   |               | $ | 157,433,544 |  
|Notes payable                                                                                                                                                  |  |                   | 1,278,181   |   |               |   | 1,197,806   |  
|Note payable - ESOP                                                                                                                                            |  |                   | 70,420      |   |               |   | 70,420      |  
|Advances from Federal Home Loan Bank                                                                                                                           |  |                   | 42,143,248  |   |               |   | 33,143,754  |  
|Accounts payable and other liabilities                                                                                                                         |  |                   | 1,807,735   |   |               |   | 1,764,907   |  
|Redeemable common stock held by the ESOP, net of unearned ESOP shares                                                                                          |  |                   | 554,322     |   |               |   | 534,750     |  
|Capital securities                                                                                                                                             |  |                   | 5,000,000   |   |               |   | 5,000,000   |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|Total liabilities                                                                                                                                              |  |                   | 208,819,450 |   |               |   | 199,145,181 |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|Commitments and Contingencies                                                                                                                                  |  |                   |             |   |               |   |             |  
|                                                                                                                                                               |  |                  
|Stockholders Equity:                                                                                                                                          |  |                   |             |   |               |   |             |  
|Common stock, par value $.01 per share; authorized 5,000,000 shares; 1,053,675 issued and 1,049,835 outstanding shares at September 30, 2004
and June 30, 2004 |  |                   | 10,537      |   |               |   | 10,537      |  
|Additional paid-in capital                                                                                                                                     |  |                   | 4,661,333   |   |               |   | 4,653,933   |  
|Retained earnings, substantially restricted                                                                                                                    |  |                   | 7,997,254   |   |               |   | 7,874,017   |  
|Accumulated other comprehensive income                                                                                                                         |  |                   | 38,606      |   |               |   | 10,389      |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|                                                                                                                                                               |  |                   | 12,707,730  |   |               |   | 12,548,876  |  
|Less the cost of 3,840 shares of treasury stock                                                                                                                |  |                   | (74,880     | ) |               |   | (74,880     | )
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|Total stockholders equity                                                                                                                                     |  |                   | 12,632,850  |   |               |   | 12,473,996  |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  
|Total liabilities and stockholders equity                                                                                                                     |  | $                 | 221,452,300 |   |               | $ | 211,619,177 |  
|                                                                                                                                                               |  |                   |             |   |               |   |             |  



See Notes to Condensed Consolidated
Financial Statements.

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|* | The Condensed Consolidated Statement of Financial Condition as of June 30, 2004 has been derived from audited consolidated financial statements.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------



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AF FINANCIAL GROUP AND SUBSIDIARIES



CONDENSED
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)

For the Three Months Ended September 30, 2004 and 2003



|                                                    |  |                                 |           |      |   |           |  
|--------------------------------------------------- |  | ------------------------------- | --------- | ---- | - | --------- | -
|                                                    |  | Three Months EndedSeptember 30, |          
|                                                    |  | 2004                            |           | 2003 |  
|Interest and dividend income:                       |  |                                 |           |      |   |           |  
|Loans                                               |  | $                               | 2,822,741 |      | $ | 2,610,032 |  
|Investment securities                               |  |                                 | 55,290    |      |   | 55,288    |  
|Interest-bearing deposits                           |  |                                 | 6,474     |      |   | 18,491    |  
|                                                    |  |                                 |           |      |   |           |  
|Total interest income                               |  |                                 | 2,884,505 |      |   | 2,683,811 |  
|                                                    |  |                                 |           |      |   |           |  
|Interest expense:                                   |  |                                 |           |      |   |           |  
|Savings deposits                                    |  |                                 | 647,520   |      |   | 732,811   |  
|Federal Home Loan Bank advances                     |  |                                 | 320,974   |      |   | 263,693   |  
|Notes payable                                       |  |                                 | 15,729    |      |   | 17,190    |  
|Capital securities                                  |  |                                 | 129,801   |      |   | 131,284   |  
|                                                    |  |                                 |           |      |   |           |  
|Total interest expense                              |  |                                 | 1,114,024 |      |   | 1,144,978 |  
|                                                    |  |                                 |           |      |   |           |  
|Net interest income                                 |  |                                 | 1,770,481 |      |   | 1,538,833 |  
|Provision for loan losses                           |  |                                 | 80,000    |      |   | 44,000    |  
|                                                    |  |                                 |           |      |   |           |  
|Net interest income after provision for loan losses |  |                                 | 1,690,481 |      |   | 1,494,833 |  
|                                                    |  |                                 |           |      |   |           |  
|Noninterest income:                                 |  |                                 |           |      |   |           |  
|Insurance commissions                               |  |                                 | 676,462   |      |   | 613,505   |  
|Other                                               |  |                                 | 338,305   |      |   | 303,955   |  
|                                                    |  |                                 |           |      |   |           |  
|                                                    |  |                                 | 1,014,767 |      |   | 917,460   |  
|                                                    |  |                                 |           |      |   |           |  
|Noninterest expense:                                |  |                                 |           |      |   |           |  
|Compensation and employee benefits                  |  |                                 | 1,383,355 |      |   | 1,366,078 |  
|Occupancy and equipment                             |  |                                 | 311,828   |      |   | 304,179   |  
|Computer processing charges                         |  |                                 | 166,443   |      |   | 142,803   |  
|Other                                               |  |                                 | 553,139   |      |   | 519,212   |  
|                                                    |  |                                 |           |      |   |           |  
|                                                    |  |                                 | 2,414,765 |      |   | 2,332,272 |  
|                                                    |  |                                 |           |      |   |           |  
|Income before income taxes                          |  |                                 | 290,483   |      |   | 80,021    |  
|Income taxes                                        |  |                                 | 131,160   |      |   | 47,812    |  
|                                                    |  |                                 |           |      |   |           |  
|Net income                                          |  |                                 | 159,323   |      |   | 32,209    |  
|                                                    |  |                                 |           |      |   |           |  
|Other comprehensive income, net of tax:             |  |                                 |           |      |   |           |  
|Unrealized gain (loss) on securities, net of tax    |  |                                 | 28,217    |      |   | (12,730   | )
|                                                    |  |                                 |           |      |   |           |  
|Comprehensive income                                |  | $                               | 187,540   |      | $ | 19,479    |  
|                                                    |  |                                 |           |      |   |           |  
|Basic Earnings (loss) per share of common stock     |  | $                               | 0.15      |      | $ | 0.03      |  
|                                                    |  |                                 |           |      |   |           |  
|Diluted Earnings (loss) per share of common stock   |  | $                               | 0.15      |      | $ | 0.03      |  
|                                                    |  |                                 |           |      |   |           |  
|Basic weighted average shares outstanding           |  |                                 | 1,043,409 |      |   | 1,039,709 |  
|                                                    |  |                                 |           |      |   |           |  
|Diluted weighted average shares outstanding         |  |                                 | 1,043,409 |      |   | 1,040,168 |  
|                                                    |  |                                 |           |      |   |           |  
|Cash dividends declared per share                   |  | $                               | 0.05      |      | $ | 0.05      |  
|                                                    |  |                                 |           |      |   |           |  



See
Notes to Condensed Consolidated Financial Statements



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AF FINANCIAL GROUP AND SUBSIDIARIES



CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

For the Three Months Ended September 30, 2004 and 2003



|                                                                                            |  |                                 |            |   |      |   |            |  
|------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                            |  | Three Months EndedSeptember 30, |           
|                                                                                            |  | 2004                            |            |   | 2003 |  
|Cash Flows from Operating Activities                                                        |  |                                 |            |   |      |   |            |  
|Net income                                                                                  |  | $                               | 159,323    |   |      | $ | 32,209     |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |  |                                 |            |   |      |   |            |  
|Provision for loan losses                                                                   |  |                                 | 80,000     |   |      |   | 44,000     |  
|Depreciation                                                                                |  |                                 | 223,837    |   |      |   | 212,321    |  
|ESOP Expense                                                                                |  |                                 | 16,659     |   |      |   | 18,787     |  
|Change in operating assets and liabilities:                                                 |  |                                 |            |   |      |   |            |  
|Accrued interest receivable                                                                 |  |                                 | (72,150    | ) |      |   | 44,906     |  
|Accrued interest payable                                                                    |  |                                 | (172,439   | ) |      |   | (106,652   | )
|Prepaid expense and other assets                                                            |  |                                 | (219,767   | ) |      |   | 70,814     |  
|Accounts payable and other liabilities                                                      |  |                                 | 165,983    |   |      |   | (402,605   | )
|                                                                                            |  |                                 |            |   |      |   |            |  
|Net cash provided by (used in) operating activities                                         |  |                                 | 181,447    |   |      |   | (86,220    | )
|                                                                                            |  |                                 |            |   |      |   |            |  
|Cash Flows from Investing Activities                                                        |  |                                 |            |   |      |   |            |  
|Increase in Federal Home Loan Bank stock                                                    |  |                                 | (450,000   | ) |      |   |           |  
|Purchases of investments held to maturity                                                   |  |                                 | (285,000   | ) |      |   |           |  
|Proceeds from maturities of investments held to maturity                                    |  |                                 | 290,000    |   |      |   |           |  
|Purchases of securities available for sale                                                  |  |                                 | (800,000   | ) |      |   | (1,500,000 | )
|Proceeds from principal repayment and maturities of securities available for sale           |  |                                 | 1,467,301  |   |      |   | 2,046,150  |  
|Net originations of loans receivable                                                        |  |                                 | (7,958,302 | ) |      |   | (272,908   | )
|Purchases of office properties and equipment                                                |  |                                 | (1,205,413 | ) |      |   | (684,202   | )
|Proceeds from sale of real estate owned                                                     |  |                                 |           |   |      |   | 5,260      |  
|                                                                                            |  |                                 |            |   |      |   |            |  
|Net cash used in investing activities                                                       |  |                                 | (8,941,414 | ) |      |   | (405,700   | )
|                                                                                            |  |                                 |            |   |      |   |            |  
|Cash Flows from Financing Activities                                                        |  |                                 |            |   |      |   |            |  
|Net increase in savings deposits                                                            |  |                                 | 581,284    |   |      |   | 3,286,648  |  
|FHLB Advances, net                                                                          |  |                                 | 8,999,494  |   |      |   | (463       | )
|Notes Payable, net                                                                          |  |                                 | 80,375     |   |      |   | 55,891     |  
|Dividends paid                                                                              |  |                                 | (25,773    | ) |      |   | (24,430    | )
|                                                                                            |  |                                 |            |   |      |   |            |  
|Net cash provided by financing activities                                                   |  |                                 | 9,635,380  |   |      |   | 3,317,646  |  
|                                                                                            |  |                                 |            |   |      |   |            |  
|Net increase in cash and cash equivalents                                                   |  |                                 | 875,413    |   |      |   | 2,825,726  |  
|Cash and cash equivalents:                                                                  |  |                                 |            |   |      |   |            |  
|Beginning                                                                                   |  |                                 | 7,674,052  |   |      |   | 14,072,018 |  
|                                                                                            |  |                                 |            |   |      |   |            |  
|Ending                                                                                      |  | $                               | 8,549,465  |   |      | $ | 16,897,744 |  
|                                                                                            |  |                                 |            |   |      |   |            |  



See Notes to Condensed
Consolidated Financial Statements.



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AF FINANCIAL GROUP



NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



Note 1. Nature of Business



AF Financial Group (the Company) is a federally chartered
stock holding company for AF Bank (the Bank), AF Insurance Services, Inc. (an independent insurance agency) and AF Brokerage, Inc. (a registered broker/dealer, member NASD and SIPC). AF Bank conducts business from its main office located
in West Jefferson, North Carolina, with branches in Boone, Jefferson, Sparta, Warrensville, and West Jefferson, North Carolina. Headquartered in West Jefferson, North Carolina, AF Insurance Services, Inc., has branches in Boone, Elkin, Jefferson,
Lenoir, Sparta, West Jefferson, and North Wilkesboro, North Carolina. AF Brokerage, Inc. serves Ashe, Alleghany, Wilkes and Watauga counties in North Carolina.



Note 2. Basis of Presentation



The accompanying unaudited condensed consolidated financial statements (except for the condensed consolidated statement of financial condition at June 30, 2004, which is
derived from audited consolidated financial statements) have been prepared in accordance with accounting principles generally accepted in the United States (US GAAP) for interim financial information and with the instructions to Form
10-QSB of Regulation S-B. Accordingly, they do not include all of the information and footnotes required by US GAAP for complete financial statements. In the opinion of management, all adjustments (none of which were other than normal recurring
accruals) necessary for a fair presentation of the financial position and results of operations for the periods presented have been included. The results of operations for the three month period ended September 30, 2004 are not necessarily
indicative of the results of operations that may be expected for the Companys fiscal year ending June 30, 2005.



Certain amounts in the three-month period ended September 30, 2003 financial statements have been reclassified to conform to the three-month period ended September 30,
2004 presentation. The reclassifications had no effect on net income or stockholders equity as previously reported.



The accounting policies which follow are as set forth in Note 1 of the Notes to Consolidated Financial Statements in the Companys 2004 audited consolidated
financial statements, which are included in the Companys Annual Report on Form 10-KSB for the year ended June 30, 2004. This quarterly report should be read in conjunction with such annual report.



Note 3. Earnings Per Share



The Companys basic and dilutive earnings per share for the three-month period ended
September 30, 2004 are based on a weighted average of 1,043,409 shares, assumed to be outstanding for the period. The Companys basic and dilutive earnings per share for the three-month period ended September 30, 2003 are based on weighted
averages of 1,039,709 and 1,040,168 shares, respectively, assumed to be outstanding for the period. Basic earnings per share amounts are based on the weighted average shares of common stock outstanding. Diluted earnings per share assumes the
exercise or issuance of all potential common stock instruments such as options, unless the effect is antidilutive (to reduce a loss or increase earnings per share) as was the case for the



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three-month period ended September 30, 2004. Shares owned by the Companys ESOP that have not been committed to be
released are not considered to be outstanding for the purposes of computing earnings per share. Earnings per share have been calculated in accordance with Statement of Position 93-6 Employers Accounting for Employee Stock Ownership
Plans and Statement of Financial Accounting Standards Number 128.



Earnings per share have been computed using the weighted average number of shares of common stock and potentially dilutive common stock equivalents outstanding as follows:



|                                                                                            |  |                                 |  |          
|------------------------------------------------------------------------------------------- |  | ------------------------------- |  | ---------
|                                                                                            |  | Three Months EndedSeptember 30,
|                                                                                            |  | 2004                            |  | 2003     
|Weighted average shares outstanding                                                         |  | 1,043,409                       |  | 1,039,709
|                                                                                            |  |                                
|Potentially Dilutive effect of stock options                                                |  |                                |  | 459      
|                                                                                            |  |                                 |  |          
|Weighted average shares outstanding, including potentially dilutive effect of stock options |  | 1,043,409                       |  | 1,040,168
|                                                                                            |  |                                 |  |          



For the three-months ended September
30, 2004 there were 14,573 options that were antidilutive, since the exercise price was greater than the average market price for the quarter. There were no antidilutive options outstanding for the three-months ended September 30, 2003.



Note 4. Capital Securities



On July 16, 2001, AF Capital Trust (the Trust), a Delaware business trust formed
by the Company, completed the sale of $5.0 million of 10.25% Capital Securities (liquidation amount of $1,000 per security) (the Capital Securities) in a private placement as part of a pooled capital securities transaction. The Trust
also issued Common Securities to the Company and used the net proceeds from the offering to purchase a like amount of 10.25% Junior Subordinated Deferrable Interest Debentures (the Subordinated Debentures) of the Company. The
Subordinated Debentures are the sole assets of the Trust and are eliminated, along with the related income statement effects, from the consolidated financial statements of the Company. The Company contributed $3.0 million of the proceeds from the
sale of the Subordinated Debentures to the Bank as Tier I Capital to support the Banks growth. Total expenses associated with the offering approximating $173,262 at September 30, 2004 are included in other assets and are being amortized on a
straight-line basis over the life of the Subordinated Debentures.



The Capital
Securities accrue and pay distributions semi-annually on January 25thand July 25thof each year, commencing on January 25, 2002, at a fixed annual rate of 10.25% of the stated liquidation amount of $1,000 per Capital Security. The
Company has fully and unconditionally guaranteed all of the obligations of the Trust, including the semi-annual distributions and payments on liquidation or redemption of the Capital Securities.



The Capital Securities are mandatorily redeemable upon the maturing of the Subordinated
Debentures on July 25, 2031 or upon earlier redemption as provided in the Indenture. The Company has the right to redeem the Subordinated Debentures, in whole or in part, on any January 25thor July 25thon or after
July 25, 2006 at the liquidation amount, plus any accrued but unpaid interest to the redemption date.



In January 2003, the FASB issued FASB Interpretation No. (FIN) 46, Consolidation of Variable Interest Entities.This interpretation addresses the consolidation by business enterprises of



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variable interest entities as defined in the interpretation. In December 2003, the FASB issued a revision to FIN 46 (FIN
46R) to clarify some of the provisions of FIN 46 and to exempt certain entities from its requirements. Small business issuers must apply FIN 46R no later than the end of the first reporting period ending after December 15, 2004. FIN 46 is effective
for public entities that have interests in structures that are commonly referred to as special-purpose entities for periods ending after December 15, 2003.



Adoption of FIN 46R will result in deconsolidation of the Companys Capital Securities subsidiary, AF Capital Trust. Upon deconsolidation, the Subordinated
Debentures will be included in long-term debt and the Companys equity interest in the trust will be included in other assets. If this trust was deconsolidated as of September 30, 2004 and June 30, 2004, the effect on the Companys balance
sheets for both dates would be an increase in other assets of $155,000 with a corresponding increase in long-term debt. The deconsolidation of the trust will not materially impact net income.



The Capital Securities presently qualify as Tier 1 regulatory capital. The Subordinated
Debentures do not qualify as Tier 1 regulatory capital. On July 2, 2003, the Board of Governors of the Federal Reserve issued a letter, SR 03-13, stating that notwithstanding FIN 46, trust preferred securities, including the Capital Securities, will
continue to be included in Tier 1 capital until notice is given to the contrary. There can be no assurance that the regulators will continue to allow institutions to include the Capital Securities in Tier I capital for regulatory capital purposes.
In the event of a disallowance, there would be a reduction in the Companys consolidated capital ratios. However, the Company believes that its subsidiary bank would still exceed the regulatory required minimums for capital adequacy purposes.



Note 5. Dividends Declared



On September 24, 2004, the Board of Directors of the Company declared a dividend of $0.05 a
share for stockholders of record as of September 24, 2004 and payable on October 8, 2004. The dividends declared were accrued and reported in accounts payable and other liabilities in the September 30, 2004 Consolidated Statement of Financial
Condition. AsheCo, MHC, the mutual holding company, waived the receipt of dividends declared by the Company.



Note 6. Income Taxes



Income taxes
resulted from applying normal, expected tax rates on income earned and on losses during the three months ended September 30, 2004 and 2003. The income tax expense was $131,160 for the three months ended September 30, 2004 compared to the income tax
expense of $47,812 for the three months ended September 30, 2003. The effective tax rate was higher than expected tax rates, resulting primarily from the fact that North Carolina corporations may not file consolidated income tax returns. This had
the effect of taxing all income in a particular member of a consolidated group without permitting an offsetting benefit for losses incurred in another member of the same group, creating a higher than expected overall state income tax
expense.



Note 7. Segment Reporting



The Company has additional reportable segments, AF Bank, AF Insurance Services, Inc. and AF
Brokerage, Inc. AF Bank is a federally chartered stock savings bank. The principal activities of the Bank consist of obtaining savings deposits and providing credit to customers in its primary market area. AF Insurance Services, Inc. and AF
Brokerage, Inc. provide insurance and noninsured investment services respectively. Information about reportable segments and reconciliation of such information to the condensed consolidated financial statements as of the three month periods ended
September 30, 2004 and 2003 is as follows (dollars in thousands):



6



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##### Table of Contents

|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|----------------------------------- |  | ---------------- | ---- | - | ------- | - | ------------------------- |  | - | ---------------- | - |  | ------------------------- | --- | - | ------------------ | - | ---- | - |  | - | -------
|                                    |  | AFFinancialGroup |      |   | AF Bank |   | AFInsuranceServices, Inc. |  |   | AF BrokerageInc. |   |  | Inter- segmentElimination |     |   | ConsolidatedTotals
|September 30, 2004                  |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|                                    |  |                  |      |   |         |  
|Interest income                     |  | $                |     |   |         | $ | 2,886                     |  | $ |                 |   |  | $                         |    |   |                    | $ | (2   | ) |  | $ | 2,884  
|                                    |  |                  |      |   |         |  
|Interest expense                    |  |                  | 131  |   |         |   | 970                       |  |   | 15               |   |  |                           |    |   |                    |   | (2   | ) |  |   | 1,114  
|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|Net interest income                 |  |                  | (131 | ) |         |   | 1,916                     |  |   | (15              | ) |  |                           |    |   |                    |   |     |   |  |   | 1,770  
|Provision for loan losses           |  |                  |     |   |         |   | 80                        |  |   |                 |   |  |                           |    |   |                    |   |     |   |  |   | 80     
|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|Net interest income after provision |  |                  | (131 | ) |         |   | 1,836                     |  |   | (15              | ) |  |                           |    |   |                    |   |     |   |  |   | 1,690  
|Non-interest income                 |  |                  |     |   |         |   | 341                       |  |   | 701              |   |  |                           | 62  |   |                    |   | (89  | ) |  |   | 1,015  
|Non-interest expense                |  |                  | 76   |   |         |   | 1,761                     |  |   | 570              |   |  |                           | 97  |   |                    |   | (89  | ) |  |   | 2,415  
|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|Income (loss) before income taxes   |  |                  | (207 | ) |         |   | 416                       |  |   | 116              |   |  |                           | (35 | ) |                    |   |     |   |  |   | 290    
|Income taxes                        |  |                  | (66  | ) |         |   | 162                       |  |   | 45               |   |  |                           | (10 | ) |                    |   |     |   |  |   | 131    
|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|Net income (loss)                   |  | $                | (141 | ) |         | $ | 254                       |  | $ | 71               |   |  | $                         | (25 | ) |                    | $ |     |   |  | $ | 159    
|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        
|Assets                              |  | $                | 293  |   |         | $ | 219,023                   |  | $ | 2,375            |   |  | $                         | 207 |   |                    | $ | (446 | ) |  | $ | 221,452
|                                    |  |                  |      |   |         |   |                           |  |   |                  |   |  |                           |     |   |                    |   |      |   |  |   |        



|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|----------------------------------- |  | ---------------- | ---- | - | ------- | - | ------------------------- |  | - | --------------- | - |  | ------------------------- | --- | - | ------------------ | - | ---- | - |  | - | -------
|                                    |  | AFFinancialGroup |      |   | AF Bank |   | AFInsuranceServices, Inc. |  |   | AFBrokerageInc. |   |  | Inter- segmentElimination |     |   | ConsolidatedTotals
|September 30, 2003                  |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|                                    |  |                  |      |   |         |  
|Interest income                     |  | $                |     |   |         | $ | 2,686                     |  | $ |                |   |  | $                         |    |   |                    | $ | (2   | ) |  | $ | 2,684  
|                                    |  |                  |      |   |         |  
|Interest expense                    |  |                  | 132  |   |         |   | 1,000                     |  |   | 15              |   |  |                           |    |   |                    |   | (2   | ) |  |   | 1,145  
|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|Net interest income                 |  |                  | (132 | ) |         |   | 1,686                     |  |   | (15             | ) |  |                           |    |   |                    |   |     |   |  |   | 1,539  
|Provision for loan losses           |  |                  |     |   |         |   | 44                        |  |   |                |   |  |                           |    |   |                    |   |     |   |  |   | 44     
|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|Net interest income after provision |  |                  | (132 | ) |         |   | 1,642                     |  |   | (15             | ) |  |                           |    |   |                    |   |     |   |  |   | 1,495  
|Non-interest income                 |  |                  |     |   |         |   | 313                       |  |   | 620             |   |  |                           | 48  |   |                    |   | (64  | ) |  |   | 917    
|Non-interest expense                |  |                  | 113  |   |         |   | 1,648                     |  |   | 560             |   |  |                           | 75  |   |                    |   | (64  | ) |  |   | 2,332  
|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|Income (loss) before income taxes   |  |                  | (245 | ) |         |   | 307                       |  |   | 45              |   |  |                           | (27 | ) |                    |   |     |   |  |   | 80     
|Income taxes                        |  |                  | (82  | ) |         |   | 120                       |  |   | 18              |   |  |                           | (8  | ) |                    |   |     |   |  |   | 48     
|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|Net income (loss)                   |  | $                | (163 | ) |         | $ | 187                       |  | $ | 27              |   |  | $                         | (19 | ) |                    | $ |     |   |  | $ | 32     
|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        
|Assets                              |  | $                | 473  |   |         | $ | 191,785                   |  | $ | 2,424           |   |  | $                         | 270 |   |                    | $ | (133 | ) |  | $ | 194,819
|                                    |  |                  |      |   |         |   |                           |  |   |                 |   |  |                           |     |   |                    |   |      |   |  |   |        



7



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AF FINANCIAL GROUP



Item 2. Managements Discussion and Analysis



This Form 10-QSB contains certain forward-looking statements consisting of estimates with respect to the financial condition, results of operations and other business of the Company, that are subject to various factors which could cause
actual results to differ materially from the estimates. These factors include: changes in general, economic and market conditions; the development of an interest rate environment that adversely affects the interest rate spread or other income
anticipated from the Companys operations and investments; our ability to offer new products and increase lower cost core deposits; and depositor and borrower preferences. The Company disclaims any obligation to publicly announce future events
or developments that may affect the forward-looking statements contained herein.



Overview



AF Financial Group is a
financial services company that provides banking, insurance and investment services to residents in the northwest corner of North Carolina. Our bank subsidiary, AF Bank, was chartered in 1939 and the historical operations of AF Bank have been to
provide fixed rate loans for the residents of Ashe County, North Carolina. Over the past several years, we have expanded our market area to include Alleghany, Caldwell, Surry, Watauga and Wilkes counties and have diversified our product lines by
engaging in non-residential mortgage and non-mortgage lending and offering insurance and brokerage products. In July 1997, we started offering traditional property and casualty, life and health insurance products through AF Insurance Services, Inc.,
a wholly-owned subsidiary of AF Financial Group, headquartered in West Jefferson, North Carolina and operating in Boone, Elkin, Jefferson, Lenoir, Sparta, West Jefferson and Wilkesboro, North Carolina. We also have a broker/dealer subsidiary, AF
Brokerage, Inc., which serves Ashe, Alleghany, Wilkes and Watauga counties. AF Brokerage offers a full array of uninsured investment products, including fixed-rate and variable annuities and mutual funds.



We believe we have the foundation in place to successfully compete in our established
markets. In all AF Bank markets, we have the capability to deliver comprehensive insurance services through our insurance subsidiary and the potential to deliver securities services through AF Brokerage, Inc. The challenge facing us is to provide
the most economical, efficient  and most importantly  desirable platform to offer AF customers, clients and prospects these services. It is a challenge we are working hard to meet.



The cost of the infrastructure that we now have in place allowing us to successfully compete
in our established markets, has had a negative impact on short term earnings. However, we believe our established foundation and platform will drive our long-term viability as a competitively superior financial services provider in all markets. We
are committed to the long-term profitability and success of AF Financial Group. Given the foregoing foundation and platform, management and the board of directors are placing major emphasis upon improving our net earnings and return on equity in the
year ended June 30, 2005 and beyond. This will be accomplished by increasing the overall productivity of AF Financial Group and its operating subsidiaries, controlling costs, and reducing or eliminating unprofitable activities whenever and wherever
possible.



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There are a number of positive factors and recent events, which reflect our progress toward our long-term goals during
the three months ended September 30, 2004:



| |  | An increase in net loans of $7.9 million or 4.3%;
| | - | -------------------------------------------------



| |  | Asset growth of $9.8 million or 4.7%;
| | - | -------------------------------------



| |  | An increase in net income of $127,114, or 394.65%, during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | An increase in noninterest income of $97,307, or 10.6% during the three months ended September 30, 2004 as compared to the three months ended September 30, 2003;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Our new Financial Center in Boone, North Carolina which opened on October 4, 2004. The Financial Center combines banking, insurance and investments into one convenient highly
visible location serving the Watauga County market.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As mentioned
above, during the three months ended September 30, 2004, we experienced asset growth of $9.8 million consisting primarily of increases in net loan balances of approximately $7.9 million. While AF Bank is currently well-capitalized under
the regulatory guidelines, a continuing increase in assets may result in AF Bank falling below regulatory capital levels required to be considered well capitalized. The maintenance of appropriate levels of capital is a priority of ours
and is monitored on an ongoing basis.



Our operating results are primarily
dependent upon net interest income, fees and charges and insurance commissions. Net interest income is the difference between interest earned on loans and investments and the interest paid on savings deposits and our borrowings. Our primary
interest-earning asset is our loan portfolio representing 85.5% of total assets. Our net interest income is affected by changes in economic conditions that influence market interest rates and to a large extent by the monetary actions by the Federal
Reserve. This exposure to changes in interest rates contributes to a moderate degree of interest rate risk, because of the negative impact of changing rates to AF Banks earnings and to the market value of its assets and liabilities.
Historically, mortgage lenders have made loans with long terms to maturity and funded those loans with core and short term deposits, exposing the lender to a higher level of interest rate risk in a rising rate scenario. We have reduced the exposure
to rising rates by limiting the term or the time to reprice the loans that we retain in our portfolio.



As mentioned above, net income increased $127,114, or 394.7%, to $159,323 for the three months ended September 30, 2004 from $32,209 for the three-month period ended September 30, 2003. This change is primarily due to
an increase in interest income due to the 50 basis point interest rate hike by the Federal Reserve during the three months ended September 30, 2004. We believe that a positive upturn in economic indicators will continue to have a positive impact on
our net income. At June 30, 2004 we had approximately $66.4 million in loans priced at prime or a margin thereto which provides for adjusting rates immediately when market rates change. In a rising rate environment, our ability to make immediate
rate adjustments serves to protect the interest margin against increases in rates at a more rapid speed than the increase in funding costs.



Critical Accounting Policies and Estimates



The notes to our audited consolidated financial statements for the year ended June 30, 2004 included in the AF Financial Group 2004 Annual Report on Form 10-KSB contain a
summary of our significant accounting policies. We believe that our policies with respect to the methodology for our determination of the allowance for loan losses, the fair value of mortgage servicing assets and asset impairment judgments,
including the recoverability of goodwill, involve a higher degree



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of complexity and require management to make difficult and subjective judgments which often require assumptions or
estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could cause reported results to differ materially. These critical policies and their application are periodically reviewed with the Audit Committee and
our Board of Directors. We consider the following accounting policies to be most critical in their potential effect on our financial position or results of operations:



Allowance for Loan Losses



The Allowance for Loan Losses (ALL) is established through a provision for loan losses based on our evaluation of the risks inherent in AF Banks loan
portfolio, prior loss history and the general economy. The ALL is maintained at an amount we consider adequate to cover loan losses which are deemed probable and estimable. The allowance is based upon a number of factors, including asset
classifications, economic trends, industry experience and trends, industry and geographic concentrations, estimated collateral values, our assessment of the credit risk inherent in the portfolio, historical loan loss experience, and AF Banks
underwriting policies. Our methodology for assessing the appropriations of the ALL consists of two components, which are specific allowance for identified problem or impaired loans and a formula allowance for the remainder of the portfolio. Although
we believe we have established and maintained the ALL at appropriate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment. We will continue to monitor
and modify our ALL as conditions dictate.



Mortgage Servicing Assets



Mortgage servicing assets represent the present value of the future net
servicing fees from servicing mortgage loans sold to the secondary market. The most critical accounting policy associated with mortgage servicing is the methodology used to determine the fair value of mortgage servicing assets, which requires the
development of a number of assumptions, including anticipated loan principal amortization and prepayments of principal. The value of mortgage servicing rights is significantly affected by mortgage interest rates available in the marketplace that
influence the speed of mortgage loan prepayments. During periods of declining interest rates, the value of mortgage servicing assets generally declines due to increasing prepayments attributable to increased mortgage refinance activity. Conversely,
during periods of rising interest rates, the value of servicing assets generally increases due to reduced refinance activity. We amortize mortgage servicing assets over the estimated period that servicing income is expected to be received based on
estimates of the amount and timing of future cash flows. The amount and timing of servicing asset amortization is adjusted quarterly based on actual results and updated projections.



Goodwill



On July 1, 2002, we adopted the provisions of Financial Accounting Standards Board Statement 142, Goodwill and Other Intangible Assets. Under the provisions of the
Statement, on July 1, 2002, we ceased to amortize goodwill. We will reevaluate the carrying value of goodwill annually by comparing the market value of each reporting segment to the respective total equity at that level. Impairment would then be
determined if the equity exceeds the fair value of the reporting unit. This evaluation is subjective as it requires material estimates that may be susceptible to significant change.



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##### Table of Contents

Comparison of Financial Condition at September 30, 2004 and June 30, 2004:



Total assets increased by $9.8 million, or 4.7%, to $221.5 million at September 30, 2004
from $211.6 million at June 30, 2004. The increase in assets was primarily the result of an increase of $7.9 million, or 4.3%, in net loans receivable and an increase of $968,756, or 8.4%, in net office properties and equipment from June 30, 2004 to
September 30, 2004. The increase in net loans receivable and net office properties and equipment was partially offset by a decrease of $626,834, or 14.5%, in securities available for sale from June 30, 2004 to September 30, 2004. The decrease in
securities available for sale was used to help fund the $7.9 million increase in net loans receivable. The increase in net loans receivable is typical for AF Bank, which operates in lending markets that have had sustained loan demand over the last
several years. The increase in net office properties and equipment was primarily due to the costs to construct the new Financial Services Center in Boone, North Carolina, which opened on October 4, 2004.



As mentioned above, securities available for sale decreased $626,834, or 14.5%, to $3.7
million at September 30, 2004 from $4.3 million at June 30, 2004. This decrease was due to maturing investments. At September 30, 2004, our investment portfolio had approximately $63,408 in net unrealized gains as compared to net unrealized gains of
$17,064 at June 30, 2004.



Net loans increased $7.9 million, or 4.3%, to $189.4
million at September 30, 2004 from $181.5 million at June 30, 2004. The following table sets forth the composition of our mortgage and other loan portfolios in dollar amounts and percentages at the dates indicated.



|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|--------------------------------------------- |  | ---------------------- | ------- | ---------- | ---------------- | - | ------ | - | ---------- |  | ------ | -
|                                              |  | At September 30, 2004  |         |            | At June 30, 2004 |  
|                                              |  | Amount                 |         | % of Total |                  |   | Amount |   | % of Total | 
|                                              |  | (Dollars in thousands) |        
|Mortgage loans:                               |  |                        |         |            |                  |   |        |   |            |  |        |  
|One-to four-family                            |  | $                      | 98,652  |            | 52.10            | % |        | $ | 96,024     |  | 52.90  | %
|Multi-family                                  |  |                        | 5,852   |            | 3.09             | % |        |   | 5,728      |  | 3.16   | %
|Non-residential                               |  |                        | 28,835  |            | 15.23            | % |        |   | 28,958     |  | 15.96  | %
|Land                                          |  |                        | 16,387  |            | 8.65             | % |        |   | 13,906     |  | 7.66   | %
|Construction                                  |  |                        | 15,838  |            | 8.36             | % |        |   | 14,203     |  | 7.83   | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|Total mortgage loans                          |  | $                      | 165,564 |            | 87.43            | % |        | $ | 158,819    |  | 87.51  | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|Other loans:                                  |  |                        |         |            |                  |   |        |   |            |  |        |  
|Commercial                                    |  | $                      | 13,644  |            | 7.21             | % |        | $ | 12,626     |  | 6.96   | %
|Consumer loans                                |  |                        | 11,684  |            | 6.17             | % |        |   | 11,512     |  | 6.34   | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|Total other loans                             |  | $                      | 25,328  |            | 13.38            | % |        | $ | 24,138     |  | 13.30  | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|Gross loans                                   |  | $                      | 190,892 |            | 100.81           | % |        | $ | 182,957    |  | 100.81 | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|Less:                                         |  |                        |         |            |                  |   |        |   |            |  |        |  
|Unearned discounts and net deferred loan fees |  | $                      | 221     |            | 0.12             | % |        | $ | 223        |  | 0.12   | %
|Allowance for loan losses                     |  |                        | 1,304   |            | 0.69             | % |        |   | 1,245      |  | 0.69   | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|                                              |  |                        | 1,525   |            | 0.81             | % |        |   | 1,468      |  | 0.81   | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  
|Loans, net                                    |  | $                      | 189,367 |            | 100.00           | % |        | $ | 181,489    |  | 100.00 | %
|                                              |  |                        |         |            |                  |   |        |   |            |  |        |  



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Savings deposits increased by $532,000, or 0.3%, from $157.4 million at June 30, 2004 to $158.0 million at September 30,
2004. We believe the increase in deposits is attributable to our continuing marketing efforts directed towards increasing balances in savings and transaction accounts and in smaller, stable certificates of deposits. We intend to further focus our
marketing efforts and to offer new products to increase lower cost core deposits.



Advances from the Federal Home Loan Bank increased $9.0 million, or 27.2%, to $42.1 million at September 30, 2004 from $33.1 million at June 30, 2004. The increase in advances from the Federal Home Loan Bank was used to provide the funding
for the $7.9 million increase in net loans receivable.



Total
stockholders equity increased $158,854, or 1.3%, to $12.6 million at September 30, 2004 from $12.5 million at June 30, 2004. The increase in stockholders equity was the primarily the result of net income of $159,323, the increase in
other comprehensive income of $28,217 and ESOP expenses of $16,659. These increases were partially offset by the increase in the value of redeemable common stock held by the ESOP of $19,572, or 3.7%, and dividends of $25,773. At September 30, 2004,
AF Banks regulatory capital amounted to $17.3 million compared to $17.0 million at June 30, 2004, which was in excess of regulatory capital requirements at both such dates.



AF Banks level of non-performing loans, defined as loans past due 90 days or more, increased to $711,691 at September 30, 2004
compared to $518,801 at June 30, 2004. The increase is primarily due to two real estate loans where the borrower lost their employment and has not been able to keep their payments current. The Bank recognized net charge-offs of approximately $20,545
during the three-month period ended September 30, 2004 compared to net charge-offs of $60,064 for the comparable period ended September 30, 2003. While future loan loss provision requirements are uncertain, management believes that similar
provisions are likely.



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##### Table of Contents

The following table sets forth activity in the Banks ALL at or for the dates indicated.



|                                                                          |  |                                              |         |   |                                               |   |         |  
|------------------------------------------------------------------------- |  | -------------------------------------------- | ------- | - | --------------------------------------------- | - | ------- | -
|                                                                          |  | For the ThreeMonths Ended September 30, 2004 |         |   | For the Three Months Ended September 30, 2003 |  
|                                                                          |  | (Dollars in thousands)                       |        
|Balance at beginning of year                                              |  | $                                            | 1,245   |   |                                               | $ | 1,111   |  
|Provision for loan losses                                                 |  |                                              | 80      |   |                                               |   | 44      |  
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Charge-offs:                                                              |  |                                              |         |   |                                               |   |         |  
|One - to four-family residential                                          |  |                                              | (16     | ) |                                               |   | (24     | )
|Multi-family residential                                                  |  |                                              |        |   |                                               |   |        |  
|Non-residential and land                                                  |  |                                              |        |   |                                               |   |        |  
|Construction                                                              |  |                                              |        |   |                                               |   |        |  
|Commercial                                                                |  |                                              |        |   |                                               |   | (33     | )
|Consumer loans                                                            |  |                                              | (42     | ) |                                               |   | (21     | )
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Total charge-offs                                                         |  |                                              | (58     | ) |                                               |   | (78     | )
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Recoveries                                                                |  |                                              | 37      |   |                                               |   | 18      |  
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Balance at end of period                                                  |  | $                                            | 1,304   |   |                                               | $ | 1,095   |  
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Total loans outstanding at end of period                                  |  | $                                            | 190,892 |   |                                               | $ | 157,776 |  
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Allowance for loan losses to total loans at end of period                 |  |                                              | 0.68    | % |                                               |   | 0.69    | %
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Allowance for loan losses to total non-performing assets at end of period |  |                                              | 183.15  | % |                                               |   | 277.22  | %
|                                                                          |  |                                              |         |   |                                               |   |         |  
|Allowance for loan losses to total non-performing loans at end of period  |  |                                              | 183.15  | % |                                               |   | 326.87  | %
|                                                                          |  |                                              |         |   |                                               |   |         |  



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Comparison of Operating Results for the Three Months Ended September 30, 2004 and 2003:



Net income for the three-month period ended September 30, 2004 increased $127,114 to
$159,323 compared to net income of $32,209 during the same period in 2003. The increase in net income during the three month period was attributable to an increase in interest income and noninterest income, partially offset by an increase in
noninterest expense and provision for loan losses. These changes are explained below.



Interest Income. Interest income increased by $200,694, or 7.5%, from $2,683,811 for the three-month period ended September 30, 2003 to $2,884,505 for the three-month period ended September 30, 2004. Interest income from loans
increased $212,709, or 8.2%, from $2,610,032 for the three-month period ended September 30, 2003 to $2,822,741 for the three-month period ended September 30, 2004. The increase in interest income from loans for the three-month period was
attributable to an increase in volume of outstanding loan balances partially offset by the decrease in the weighted average rate on portfolio loans. Net loans increased $32.9 million from $156.5 million at September 30, 2003 to $189.4 million at
September 30, 2004. The weighted average rate on portfolio loans decreased .26% from 6.22% at September 30, 2003 to 5.96% at September 30, 2004.



Interest Expense. Interest expense decreased by $30,954, or 2.7%, to $1,114,024 for the three-month period ended September 30, 2004 from $1,144,978 for the three
months ended September 30, 2003. Interest expense on deposits decreased by $85,291, or 11.6%, to $647,520 for the three months ended September 30, 2004 from $732,811 for the three months ended September 30, 2003. These decreases are the result of
the 0.2% decrease in AF Banks weighted average rate of deposits during the twelve-month period ended September 30, 2004. Interest expense on Federal Home Loan Bank advances increased $57,281, or 21.7%, from $263,693 for the three months ended
September 30, 2003 to $320,974 for the three months ended September 30, 2004. The increase in interest expense on Federal Home Loan Bank advances is the result of the $9.0 million increase in Federal Home Loan Bank advances during the three months
ended September 30, 2004. These advances were used to fund loan demand.



Net
Interest Income. Net interest income increased by $231,648, or 15.1%, from $1,538,833 for the three-month period ended September 30, 2003 to $1,770,481 for the three-month period ended September 30, 2004. The increase in net interest income is
the result of a drop in the weighted average rate paid for deposits and the increase in outstanding loan balances, partially offset by the increase in Federal Home Loan Bank borrowings. In a rising rate environment, we have the ability to make
immediate rate adjustments which allows us to increase loan rates at a more rapid speed than the increase in funding costs. We believe that a positive upturn in economic indicators will have a positive impact on our net income. We do not believe
that there has been a material change in interest rate risk from the end of our most recent fiscal year.



Provision for Loan Losses. We made provisions in the amount of $80,000 to the allowance for loan losses during the three-month period ended September 30, 2004, compared to a $44,000 provision for loan losses
made during the three-month period ended September 30, 2003.



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Provisions for loan losses, which are charged to operations and resulting loan loss allowances, are amounts that the we
believe will be adequate to absorb probable losses on existing loans that may become uncollectible. Loans are charged off against the allowance when we believe collection is unlikely. The evaluation to increase or decrease the provisions for loan
losses and resulting allowances is based both on prior loan loss experience and other factors, such as changes in the nature and volume of the loan portfolio, overall portfolio quality and current economic conditions.



We made provisions for loan loss allowances during the three-month period ended September 30,
2004 based upon an analysis of the quality of our loan portfolio. At September 30, 2004, our level of allowance for loan losses amounted to $1,304,473, or 0.68% of total loans, as compared to $1,094,620 of allowance for loan losses, or 0.69% of
total loans at September 30, 2003, which we believe is adequate to absorb any probable losses inherent in our loan portfolio



Noninterest Income. Noninterest income increased by $97,307, or 10.6%, from $917,460 for the three-month period ended September 30, 2003 to $1,014,767 for the
three months ended September 30, 2004. The changes in noninterest income during the three-month period ended September 30, 2004 were primarily attributable to increases in insurance commissions and in transaction fees on deposit account. Insurance
commissions increased by $62,957, or 10.3%, from $613,505 for the three-month period ended September 30, 2003 to $676,462 for the three months ended September 30, 2004. The increase in insurance commissions is primarily due to an increase in number
of sales due to increased emphasis on training and monitoring the sales activities of insurance producers. The increase in transaction fees on deposit accounts is primarily attributable to an increase in the number of transaction accounts. These
trends are expected to continue to produce growth in non-interest income.



Non-Interest Expense. Non-interest expense increased by $82,493, or 3.5%, from $2,332,272 for the three months ended September 30, 2003 to $2,414,765 for the three months ended September 30, 2004. The increase in non-interest expense
for the three-month period ended September 30, 2004 is primarily attributable to an increase in professional services expense due to attorney fees associated with a personnel issue and an increase in computer processing charges. Computer processing
charges increased $23,640, or 16.6%, from $142,803 for the three months ended September 30, 2003 to $166,443 for the three months ended September 30, 2004. Computer processing charges increased due to an increase in AF Banks data processing
charges which primarily resulted from an increase in the number of deposit and loan accounts and an increase in data communication line charges.



Capital Resources and Liquidity:



The term liquidity generally refers to an organizations ability to generate adequate amounts of funds to meet its needs for cash. More specifically, for
financial institutions, liquidity ensures that adequate funds are available to meet deposit withdrawals, fund loan demand and capital expenditure commitments, maintain reserve requirements, pay operating expenses, and provide funds for debt service,
dividends to stockholders, and other institutional commitments. The Companys primary sources of funds consist of deposits, borrowings, repayment and prepayment of loans, sales and participations of loans, maturities of securities and
interest-bearing deposits, and funds provided from operations. While scheduled repayments of loans and maturities of securities are predictable sources of funds, deposit flows and loan prepayments are greatly influenced by the general level of
interest rates, economic conditions, and competition. The Company uses its liquid resources primarily to fund existing and future loan commitments, to fund net deposit outflows, to invest in other interest-earning assets, to maintain liquidity, and
to meet operating expenses. For additional information about cash flows from the Companys operating, financing and investing activities, see Condensed Consolidated Statements of Cash Flow.



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Liquidity management is both a daily and long-term function of management. If we require funds beyond our ability to
generate them internally, we believe we could borrow additional funds from the Federal Home Loan Bank of Atlanta (the FHLB) and use the wholesale deposit markets. At September 30, 2004, we had borrowings of $42.1 million from the FHLB.
The Bank also maintains borrowing agreements with the Federal Reserve Bank of Richmond, VA.



The Company anticipates that it will have sufficient funds available to meet its current loan origination commitments. Certificates of deposit scheduled to mature in one year or less totaled $59.0 million at September
30, 2004. Based upon historical experience, we believe that a significant portion of such deposits will remain with the Bank.



As of September 30, 2004, cash and cash equivalents, a significant source of liquidity, totaled $8.5 million. The Office of Thrift Supervision regulations require the
Company to maintain sufficient liquidity to ensure its safe and sound operation. Given our level of liquidity and our ability to borrow from the FHLB, we believe that we will have sufficient funds available to meet anticipated future loan
commitments, unexpected deposit withdrawals, and other cash requirements.



Capital management is another important daily and long-term function of management. While we currently meet all regulatory capital levels, we monitor this level on an ongoing basis. Our principal goals related to capital management are to
provide an adequate return to shareholders while retaining a sufficient foundation from which to support future growth and to comply with all regulatory guidelines.



Off Balance-Sheet Arrangements:



The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Companys financial
condition, revenues or expenses, results of operations, liquidity, capital resources or expenditures that is material to investors.



Item 3. Controls and Procedures



The Company
maintains a system of internal controls and procedures designed to provide reasonable assurance as to the reliability of our published financial statements and other disclosures included in this report. The Companys Board of Directors,
operating through its audit committee, which is composed entirely of independent outside directors, provides oversight of the Companys financial reporting process.



Management, including the Companys President and Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Companys disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, the President and Chief Executive Officer and Chief
Financial Officer concluded that the disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded,
processed, summarized and reported as and when required.



There have been no
changes in the Companys internal control over financial reporting identified in connection with the evaluation that occurred during the Companys last fiscal quarter that has materially affected, or that is reasonably likely to materially
affect, the Companys internal control over financial reporting.



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Part II. OTHER INFORMATION



Item 1. Legal Proceedings



The
Company is not a party to, and its property is not the subject of, any pending legal proceedings at the present time other than routine litigation that is incidental to the business.



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



(a) Not applicable



(b) Not applicable



(c) During the three months ended September 30, 2004, the Company did not repurchase any of its common stock. The Company does not have a stock repurchase
program in place at the present time.



Item 3. Defaults Upon Senior Securities



None



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



None



Item 5. Other Information



(a)
Not applicable



(b) Not applicable



(c) Not applicable



(d) Not applicable



Item 6. Exhibits



|     |  |                                                                                                                                                                                                                              
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Federal Stock Charter of the Company (Incorporated by reference to Exhibit 3.1 of the Registration Statement on Form 8-A, as filed with the SEC on June 16, 1998 (the Form
8-A)).                                          
|     | 
|3.2  |  | Bylaws of the Company (Incorporated by reference to the Form 8-A).                                                                                                                                                         
|     | 
|10.1 |  | Settlement Agreement dated September 24, 2004 by and between James A. Todd and AF Financial Group (Incorporated by reference to Exhibit 99.1 of the Current Report on Form 8-K, as filed with
the SEC on September 24, 2004).
|     | 
|31.1 |  | Rule 13a-14(a)/15d-14(a) Certifications                                                                                                                                                                                      
|     | 
|32.1 |  | Section 1350 Certifications                                                                                                                                                                                                  



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SIGNATURES



In accordance with the requirements of
the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                        |  |                    |  |                                                   
|----------------------- |  | ------------------ |  | --------------------------------------------------
|                        |  | AF Financial Group
|                        |  |                   
|Dated November 12, 2004 |  | By:                |  | /s/ Melanie Paisley Miller                        
|                        |  |                    |  | Melanie Paisley Miller                            
|                        |  |                    |  | Chief Financial Officer, Executive Vice President,
|                        |  |                    |  | Secretary, Treasurer                              



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