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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-QSB

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly
period ended December 31, 2006

Commission File No: 0-24479

AF Financial Group

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



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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)

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 ̈

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

As of January 31, 2007 there were 1,050,804 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                                                                                                                   |  |        
|                                                                                                                                               | 
|Condensed Consolidated Statements of Financial Condition as of December 31, 2006 (unaudited) and June 30, 2006                                 |  | 1      
|                                                                                                                                               | 
|Condensed Consolidated Statements of Income and Comprehensive Income (unaudited) for the Three and Six Months Ended December 31, 2006 and 2005 |  | 2      
|                                                                                                                                               | 
|Condensed Consolidated Statements of Cash Flows (unaudited) for the Six Months Ended December 31, 2006 and 2005                                |  | 3      
|                                                                                                                                               | 
|Notes to Condensed Consolidated Financial Statements                                                                                           |  | 4  10 
|                                                                                                                                               | 
|Item 2.
Managements Discussion and Analysis                                                                                                   |  | 11  21
|                                                                                                                                               | 
|Item 3.
Controls and Procedures                                                                                                                |  | 21     
|                                                                                                                                               | 
|PART II  OTHER INFORMATION                                                                                                                    |  |        
|                                                                                                                                               | 
|Item 6.
Exhibits                                                                                                                               |  | 22-23  
|                                                                                                                                               | 
|Signatures                                                                                                                                     |  | 24     



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##### Table of Contents

AF FINANCIAL GROUP AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

As of December 31, 2006 and June 30, 2006



|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ----------- | - | ------------ | - | ----------- | -
|                                                                                                                                                              |  | December 31,2006 |             |   | June 30,2006 |  
|                                                                                                                                                              |  | (Unaudited)      |             |   | (*)          |  
|ASSETS                                                                                                                                                        |  |                  |             |   |              |   |             |  
|Cash and cash equivalents:                                                                                                                                    |  |                  |             |   |              |   |             |  
|Interest-bearing deposits                                                                                                                                     |  | $                | 357,967     |   |              | $ | 2,102,087   |  
|Noninterest-bearing deposits                                                                                                                                  |  |                  | 9,475,657   |   |              |   | 8,906,573   |  
|Securities available for sale                                                                                                                                 |  |                  | 17,923,407  |   |              |   | 3,457,007   |  
|Federal Home Loan Bank stock                                                                                                                                  |  |                  | 1,791,600   |   |              |   | 1,791,600   |  
|Loans                                                                                                                                                         |  |                  | 199,932,169 |   |              |   | 195,506,996 |  
|Less allowance for loan losses                                                                                                                                |  |                  | (1,788,187  | ) |              |   | (1,567,988  | )
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|Loans receivable, net                                                                                                                                         |  |                  | 198,143,982 |   |              |   | 193,939,008 |  
|Loans held for sale                                                                                                                                           |  |                  | 2,031,600   |   |              |   | 885,000     |  
|Real estate owned                                                                                                                                             |  |                  | 908,611     |   |              |   | 908,611     |  
|Office properties and equipment, net                                                                                                                          |  |                  | 12,916,095  |   |              |   | 13,105,187  |  
|Accrued interest receivable on loans                                                                                                                          |  |                  | 1,142,410   |   |              |   | 1,026,816   |  
|Accrued interest receivable on investment securities                                                                                                          |  |                  | 242,137     |   |              |   | 53,654      |  
|Prepaid expenses and other assets                                                                                                                             |  |                  | 1,394,264   |   |              |   | 1,451,134   |  
|Deferred income taxes, net                                                                                                                                    |  |                  | 68,550      |   |              |   | 79,692      |  
|Goodwill                                                                                                                                                      |  |                  | 1,611,791   |   |              |   | 1,648,468   |  
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|Total assets                                                                                                                                                  |  | $                | 248,008,071 |   |              | $ | 229,354,837 |  
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                          |  |                  |             |   |              |   |             |  
|Liabilities:                                                                                                                                                  |  |                  |             |   |              |   |             |  
|Savings deposits                                                                                                                                              |  | $                | 196,853,864 |   |              | $ | 177,012,652 |  
|Short-term borrowings                                                                                                                                         |  |                  | 4,438,168   |   |              |   | 4,939,385   |  
|Long-term borrowings                                                                                                                                          |  |                  | 29,751,921  |   |              |   | 29,858,300  |  
|Accounts payable and other liabilities                                                                                                                        |  |                  | 2,108,044   |   |              |   | 2,939,216   |  
|Redeemable common stock held by the ESOP, net of unearned ESOP shares                                                                                         |  |                  | 602,268     |   |              |   | 603,668     |  
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|Total liabilities                                                                                                                                             |  |                  | 233,754,265 |   |              |   | 215,353,221 |  
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|Commitments and Contingencies                                                                                                                                 |  |                  |             |   |              |   |             |  
|Stockholders Equity:                                                                                                                                         |  |                  |             |   |              |   |             |  
|Common stock, par value $.01 per share; authorized 5,000,000 shares; 1,054,644 issued and 1,050,804 outstanding shares at December 31,
2006 and June 30, 2006 |  |                  | 10,546      |   |              |   | 10,546      |  
|Additional paid-in capital                                                                                                                                    |  |                  | 4,743,174   |   |              |   | 4,743,174   |  
|Retained earnings, substantially restricted                                                                                                                   |  |                  | 9,573,589   |   |              |   | 9,338,743   |  
|Accumulated other comprehensive income (loss)                                                                                                                 |  |                  | 1,377       |   |              |   | (15,967     | )
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|                                                                                                                                                              |  |                  | 14,328,686  |   |              |   | 14,076,496  |  
|Less the cost of 3,840 shares of treasury stock                                                                                                               |  |                  | (74,880     | ) |              |   | (74,880     | )
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|Total stockholders equity                                                                                                                                    |  |                  | 14,253,806  |   |              |   | 14,001,616  |  
|                                                                                                                                                              |  |                  |             |   |              |   |             |  
|Total liabilities and stockholders equity                                                                                                                    |  | $                | 248,008,071 |   |              | $ | 229,354,837 |  
|                                                                                                                                                              |  |                  |             |   |              |   |             |  

See Notes to Condensed Consolidated Financial Statements.



|* | The Condensed Consolidated Statement of Financial Condition as of June 30, 2006 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

For the Three and Six Months Ended December 31, 2006 and 2005



|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|-------------------------------------------------------------- |  | ------------------------------ | --------- | ---- | ---------------------------- | --------- | ---- |  | ---- | --------- |  | - | --------- | -
|                                                               |  | Three Months EndedDecember 31, |           |      | Six Months EndedDecember 31, |          
|                                                               |  | 2006                           |           | 2005 |                              |           | 2006 |  | 2005 |          
|Interest and dividend income:                                  |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Loans                                                          |  | $                              | 3,724,496 |      | $                            | 3,242,667 |      |  | $    | 7,405,675 |  | $ | 6,339,135 |  
|Investment securities                                          |  |                                | 229,136   |      |                              | 62,048    |      |  |      | 314,457   |  |   | 108,598   |  
|Interest-bearing deposits                                      |  |                                | 40,652    |      |                              | 34,581    |      |  |      | 77,508    |  |   | 79,959    |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Total interest income                                          |  |                                | 3,994,284 |      |                              | 3,339,296 |      |  |      | 7,797,640 |  |   | 6,527,692 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Interest expense:                                              |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Savings deposits                                               |  |                                | 1,506,946 |      |                              | 921,158   |      |  |      | 2,762,577 |  |   | 1,777,927 |  
|Short-term borrowings                                          |  |                                | 110,100   |      |                              | 3,401     |      |  |      | 191,062   |  |   | 14,550    |  
|Long-term borrowings                                           |  |                                | 445,091   |      |                              | 450,549   |      |  |      | 869,293   |  |   | 898,466   |  
|Early redemption penalty on trust preferred capital securities |  |                                |          |      |                              |          |      |  |      | 384,375   |  |   |          |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Total interest expense                                         |  |                                | 2,062,137 |      |                              | 1,375,108 |      |  |      | 4,207,307 |  |   | 2,690,943 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Net interest income                                            |  |                                | 1,932,147 |      |                              | 1,964,188 |      |  |      | 3,590,333 |  |   | 3,836,749 |  
|Provision for loan losses                                      |  |                                | 216,000   |      |                              | 39,000    |      |  |      | 244,500   |  |   | 69,000    |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Net interest income after provision for loan losses            |  |                                | 1,716,147 |      |                              | 1,925,188 |      |  |      | 3,345,833 |  |   | 3,767,749 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Noninterest income:                                            |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Insurance commissions                                          |  |                                | 612,226   |      |                              | 597,328   |      |  |      | 1,268,620 |  |   | 1,282,022 |  
|Other                                                          |  |                                | 512,946   |      |                              | 404,107   |      |  |      | 963,576   |  |   | 817,128   |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|                                                               |  |                                | 1,125,172 |      |                              | 1,001,435 |      |  |      | 2,232,196 |  |   | 2,099,150 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Noninterest expense:                                           |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Compensation and employee benefits                             |  |                                | 1,463,007 |      |                              | 1,436,472 |      |  |      | 2,908,146 |  |   | 2,924,575 |  
|Occupancy and equipment                                        |  |                                | 326,551   |      |                              | 342,592   |      |  |      | 646,348   |  |   | 680,901   |  
|Computer processing charges                                    |  |                                | 102,819   |      |                              | 235,857   |      |  |      | 223,601   |  |   | 424,205   |  
|Other                                                          |  |                                | 561,766   |      |                              | 517,239   |      |  |      | 1,028,543 |  |   | 1,016,093 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|                                                               |  |                                | 2,454,143 |      |                              | 2,532,160 |      |  |      | 4,806,638 |  |   | 5,045,774 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Income before income taxes                                     |  |                                | 387,176   |      |                              | 394,463   |      |  |      | 771,391   |  |   | 821,125   |  
|Income taxes                                                   |  |                                | 127,181   |      |                              | 167,524   |      |  |      | 313,695   |  |   | 346,825   |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Net income                                                     |  |                                | 259,995   |      |                              | 226,939   |      |  |      | 457,696   |  |   | 474,300   |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Other comprehensive loss, net of tax:                          |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Unrealized gain (loss) on securities, net of tax               |  |                                | 46,564    |      |                              | (2,229    | )    |  |      | 17,344    |  |   | (28,995   | )
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Comprehensive income                                           |  | $                              | 306,559   |      | $                            | 224,710   |      |  | $    | 475,040   |  | $ | 445,305   |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Basic earnings per share of common stock                       |  | $                              | 0.25      |      | $                            | 0.22      |      |  | $    | 0.44      |  | $ | 0.45      |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Diluted earnings per share of common stock                     |  | $                              | 0.25      |      | $                            | 0.22      |      |  | $    | 0.44      |  | $ | 0.45      |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Basic weighted average shares outstanding                      |  |                                | 1,050,804 |      |                              | 1,049,005 |      |  |      | 1,050,804 |  |   | 1,048,057 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Diluted weighted average shares outstanding                    |  |                                | 1,052,033 |      |                              | 1,050,342 |      |  |      | 1,051,567 |  |   | 1,049,331 |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  
|Cash dividends declared per share                              |  | $                              | 0.05      |      | $                            | 0.05      |      |  | $    | 0.10      |  | $ | 0.10      |  
|                                                               |  |                                |           |      |                              |           |      |  |      |           |  |   |           |  

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 Six Months Ended December 31, 2006 and 2005



|                                                                                         |  |                               |             |   |      |   |             |  
|---------------------------------------------------------------------------------------- |  | ----------------------------- | ----------- | - | ---- | - | ----------- | -
|                                                                                         |  | Six Months Ended December 31, |            
|                                                                                         |  | 2006                          |             |   | 2005 |  
|Cash Flows from Operating Activities                                                     |  |                               |             |   |      |   |             |  
|Net income                                                                               |  | $                             | 457,696     |   |      | $ | 474,300     |  
|Adjustments to reconcile net income to net cash provided (used) by operating activities: |  |                               |             |   |      |   |             |  
|Provision for loan losses                                                                |  |                               | 244,500     |   |      |   | 69,000      |  
|Depreciation and amortization                                                            |  |                               | 541,291     |   |      |   | 518,955     |  
|Gain on loans held for sale                                                              |  |                               | (20,085     | ) |      |   | (15,766     | )
|Proceeds from loans held for sale                                                        |  |                               | 7,392,045   |   |      |   | 10,679,836  |  
|Origination of loans held for sale                                                       |  |                               | (8,518,560  | ) |      |   | (10,427,820 | )
|Amortization of deferred loan fees                                                       |  |                               | (41,022     | ) |      |   | (32,553     | )
|ESOP expense                                                                             |  |                               |            |   |      |   | 39,331      |  
|Tax benefit from exercise of stock options                                               |  |                               |            |   |      |   | 1,027       |  
|Change in operating assets and liabilities:                                              |  |                               |             |   |      |   |             |  
|Accrued interest receivable                                                              |  |                               | (304,077    | ) |      |   | (224,139    | )
|Accrued interest payable                                                                 |  |                               | 43,162      |   |      |   | 104,200     |  
|Prepaid expense and other assets                                                         |  |                               | 141,646     |   |      |   | 319,045     |  
|Accounts payable and other liabilities                                                   |  |                               | (919,090    | ) |      |   | 364,690     |  
|                                                                                         |  |                               |             |   |      |   |             |  
|Net cash provided (used) by operating activities                                         |  |                               | (982,494    | ) |      |   | 1,870,106   |  
|                                                                                         |  |                               |             |   |      |   |             |  
|Cash Flows from Investing Activities                                                     |  |                               |             |   |      |   |             |  
|Purchases of securities available for sale                                               |  |                               | (14,565,602 | ) |      |   |            |  
|Proceeds from principal repayment and maturities of securities available for sale        |  |                               | 124,600     |   |      |   | 167,349     |  
|Net originations of loans receivable                                                     |  |                               | (4,408,452  | ) |      |   | (2,213,883  | )
|Purchases of office properties and equipment                                             |  |                               | (309,827    | ) |      |   | (342,177    | )
|                                                                                         |  |                               |             |   |      |   |             |  
|Net cash used in investing activities                                                    |  |                               | (19,159,281 | ) |      |   | (2,388,711  | )
|                                                                                         |  |                               |             |   |      |   |             |  
|Cash Flows from Financing Activities                                                     |  |                               |             |   |      |   |             |  
|Net increase in savings deposits                                                         |  |                               | 19,625,593  |   |      |   | 6,797,510   |  
|Short-term borrowings (repayments), net                                                  |  |                               | (501,217    | ) |      |   | (2,270,544  | )
|Long-term borrowings (repayments), net                                                   |  |                               | (106,379    | ) |      |   | 12,844      |  
|Net proceeds from common stock issued                                                    |  |                               |            |   |      |   | 17,927      |  
|Dividends paid                                                                           |  |                               | (51,258     | ) |      |   | (51,642     | )
|                                                                                         |  |                               |             |   |      |   |             |  
|Net cash provided by financing activities                                                |  |                               | 18,966,739  |   |      |   | 4,506,095   |  
|                                                                                         |  |                               |             |   |      |   |             |  
|Net increase (decrease) in cash and cash equivalents                                     |  |                               | (1,175,036  | ) |      |   | 3,987,490   |  
|                                                                                         |  |                               |             |   |      |   |             |  
|Cash and cash equivalents:                                                               |  |                               |             |   |      |   |             |  
|Beginning                                                                                |  |                               | 11,008,660  |   |      |   | 8,808,528   |  
|                                                                                         |  |                               |             |   |      |   |             |  
|Ending                                                                                   |  | $                             | 9,833,624   |   |      | $ | 12,796,018  |  
|                                                                                         |  |                               |             |   |      |   |             |  

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 thrift holding company which owns 100% of the common stock of AF Bank (the Bank), AF Insurance Services, Inc. (an independent insurance agency) and Ashe Lane Capital Trust (a Delaware
business trust). 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.

Note 2.
Basis of Presentation

The accompanying unaudited condensed consolidated financial statements (except for the condensed consolidated statement of
financial condition at June 30, 2006, 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 and six
month periods ended December 31, 2006 are not necessarily indicative of the results of operations that may be expected for the Companys fiscal year ending June 30, 2007.

The Companys accounting policies are set forth in Note 1 of the Notes to Consolidated Financial Statements in the Companys 2006 audited consolidated financial statements, which are included in the
Companys Annual Report on Form 10-KSB for the year ended June 30, 2006. This quarterly report should be read in conjunction with such annual report.

Note 3. Earnings Per Share

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). 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 No. 128 Earnings Per Share.



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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 EndedDecember 31, |  | Six Months EndedDecember 31,
|                                                                                            |  | 2006                           |  | 2005                         |  | 2006      |  | 2005     
|Weighted average shares outstanding                                                         |  | 1,050,804                      |  | 1,049,005                    |  | 1,050,804 |  | 1,048,057
|Potentially dilutive effect of stock options                                                |  | 1,229                          |  | 1,337                        |  | 763       |  | 1,274    
|                                                                                            |  |                                |  |                              |  |           |  |          
|Weighted average shares outstanding, including potentially dilutive effect of stock options |  | 1,052,033                      |  | 1,050,342                    |  | 1,051,567 |  | 1,049,331
|                                                                                            |  |                                |  |                              |  |           |  |          

Note 4. Dividends Declared

On December 22, 2006, the Board of Directors of the Company declared a dividend of $0.05 a share for stockholders of record as of January 5, 2007 and payable on January 19, 2007. The dividends declared
were accrued and reported in accounts payable and other liabilities in the December 31, 2006 Consolidated Statement of Financial Condition. AsheCo, MHC, the mutual holding company, waived the receipt of dividends declared by the Company.

Note 5. Adoption of Staff Accounting Bulletin Number 108

In September 2006, the Securities and Exchange Commissions Office of the Chief Accountant and its Division of Corporation Finance issued Staff Accounting Bulletin (SAB) No. 108, Considering the Effects of Prior
Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 is effective for financial statements for fiscal years ending after November 15, 2006, with earlier application encouraged in any report for an
interim period of the first fiscal year ending after November 15, 2006 and filed after September 13, 2006. SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement
misstatements.

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

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

SAB 108 permits public
companies to initially apply its provisions either by (i) restating prior financial statements as if the dual approach had always been used or (ii) recording the cumulative effect of initially applying the dual
approach as adjustments to the carrying values of assets and liabilities with an offsetting adjustment recorded to the opening balance of retained earnings. Use of the cumulative effect transition method requires detailed
disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when it arose.

We adopted SAB
108 during the quarter ended September 30, 2006 and elected to use the cumulative effect transition method in connection with the preparation of our financial statements for the six months ending December 31, 2006. The following table
summarizes the effects of applying the guidance in SAB 108.



5



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##### Table of Contents

|                                                          |  |                                                |      |   |                        |      |     |                                       |  |   |     |   |  |   |      |  
|--------------------------------------------------------- |  | ---------------------------------------------- | ---- | - | ---------------------- | ---- | --- | ------------------------------------- |  | - | --- | - |  | - | ---- | -
|                                                          |  | Period in which theMisstatement Originated (1) |      |   |                        |     
|                                                          |  | CumulativePrior to July 1, 2004                |      |   | Year Ended June 30,    |      |     | AdjustmentRecorded as of July 1, 2006 | 
|                                                          |  |                                                | 2005 |   |                        | 2006 |     |                                      
|                                                          |  |                                                |      |   | (Dollars in thousands) |      |     |                                       | 
|Accrued Vacation (2)                                      |  | $                                              | (111 | ) |                        | $    | (3  | )                                     |  | $ | 54  |   |  | $ | (60  | )
|Amortization of Intangible Assets (3)                     |  |                                                | (11  | ) |                        |      | (10 | )                                     |  |   | (10 | ) |  |   | (31  | )
|Mortgage Servicing Assets (4)                             |  |                                                | 246  |   |                        |      | (80 | )                                     |  |   | (47 | ) |  |   | 119  |  
|Overstatement of Interest Income (5)                      |  |                                                | (136 | ) |                        |      | (59 | )                                     |  |   | (26 | ) |  |   | (221 | )
|Income Tax Effect of Above Differences (6)                |  |                                                | 5    |   |                        |      | 59  |                                       |  |   | 11  |   |  |   | 75   |  
|(Understatement) Overstatement of Income Tax Accounts (7) |  |                                                | (38  | ) |                        |      | 4   |                                       |  |   | (21 | ) |  |   | (55  | )
|                                                          |  |                                                |      |   |                        |      |     |                                       |  |   |     |   |  |   |      |  
|Impact on net income (8)                                  |  | $                                              | (45  | ) |                        | $    | (89 | )                                     |  | $ | (39 | ) |  |   |      |  
|                                                          |  |                                                |      |   |                        |      |     |                                       |  |   |     |   |  |   |      |  
|Retained Earnings (9)                                     |  |                                                |      |   |                        |      |     |                                       |  |   |     |   |  | $ | (173 | )
|                                                          |  |                                                |      |   |                        |      |     |                                       |  |   |     |   |  |   |      |  



|(1) | We evaluated these errors under the roll-over method and concluded that they are immaterial individually and in the aggregate.
|--- | ------------------------------------------------------------------------------------------------------------------------------



|(2) | We did not record a liability for employee vacation accrual prior to the fiscal year beginning July 1, 2003. As a result of this error, our vacation expense was understated by
$111,000 (cumulatively) in fiscal years beginning prior to July 1, 2004, by $3,000 in fiscal year ending June 30, 2005 and was overstated by $54,000 in fiscal year ending June 30, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | We incorrectly did not amortize insurance agency customer policies acquired. As a result of this error amortization expense was understated by $11,000 (cumulatively) prior to the
fiscal year beginning July 1, 2004, by $10,000 in fiscal year ending June 30, 2005 and by $10,000 in fiscal year ending June 30, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | We understated mortgage servicing assets prior to the fiscal year beginning July 1, 2003. As a result of this error, our servicing asset income was understated by $246,000
(cumulatively) in fiscal years beginning prior to July 1, 2004, overstated by $80,000 in fiscal year ending June 30, 2005 and overstated by $47,000 in fiscal year ending June 30, 2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(5) | We incorrectly recorded the first months interest income on loans sold to the secondary market. As a result of this error our interest income was overstated by $136,000
(cumulatively) in fiscal years beginning prior to July 1, 2004, $59,000 in fiscal year ended June 30, 2005 and $26,000 in fiscal year ended June 30, 2006.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) | As a result of the misstatements described, our provision for income taxes was overstated by $5,000 (cumulatively) in fiscal years beginning prior to July 1, 2004, by $59,000
for fiscal year ended June 30, 2005 and by $26,000 for fiscal year ended June 30, 2006.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(7) | We incorrectly recorded our tax liability. As a result of this error our tax expense was understated by $38,000 (cumulatively) in fiscal years beginning prior to July 1, 2004,
overstated by $4,000 in fiscal year ended June 30, 2005 and was understated by $21,000 in fiscal year ended June 30, 2006.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(8) | Represents the net overstatement of net income for the indicated periods resulting from the misstatements described above.
|--- | --------------------------------------------------------------------------------------------------------------------------



|(9) | Represents the net reduction to retained earnings recorded as of July 1, 2006 to record the initial application of SAB 108.
|--- | ---------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Note 6. Stockholders Equity



|                                                                        |  |             |        |                          |   |                  |  |   |                                            |   |  |               |         |   |                          |   |         |   |  |   |            |  
|----------------------------------------------------------------------- |  | ----------- | ------ | ------------------------ | - | ---------------- |  | - | ------------------------------------------ | - |  | ------------- | ------- | - | ------------------------ | - | ------- | - |  | - | ---------- | -
|                                                                        |  | CommonStock |        | AdditionalPaid-inCapital |   | RetainedEarnings |  |   | AccumulatedOtherComprehensiveIncome (Loss) |   |  | TreasuryStock |         |   | TotalStockholdersEquity |  
|Balance, June 30, 2006                                                  |  | $           | 10,546 |                          | $ | 4,743,174        |  | $ | 9,338,743                                  |   |  | $             | (15,967 | ) |                          | $ | (74,880 | ) |  | $ | 14,001,616 |  
|Cumulative effect of adoption of SAB 108, net of tax benefit of $75,740 |  |             |       |                          |   |                 |  |   | (172,992                                   | ) |  |               |        |   |                          |   |        |   |  |   | (172,992   | )
|Transfer to redeemable common stock net of unearned ESOP shares         |  |             |       |                          |   |                 |  |   | 1,400                                      |   |  |               |        |   |                          |   |        |   |  |   | 1,400      |  
|Cash dividend, $.05 per share                                           |  |             |       |                          |   |                 |  |   | (51,258                                    | ) |  |               |        |   |                          |   |        |   |  |   | (51,258    | )
|Net income                                                              |  |             |       |                          |   |                 |  |   | 457,696                                    |   |  |               |        |   |                          |   |        |   |  |   | 457,696    |  
|Unrealized holding gain arising during period, net of tax of $885       |  |             |       |                          |   |                 |  |   |                                           |   |  |               | 17,344  |   |                          |   |        |   |  |   | 17,344     |  
|                                                                        |  |             |        |                          |   |                  |  |   |                                            |   |  |               |         |   |                          |   |         |   |  |   |            |  
|Balance, December 31, 2006                                              |  | $           | 10,546 |                          | $ | 4,743,174        |  | $ | 9,573,589                                  |   |  | $             | 1,377   |   |                          | $ | (74,880 | ) |  | $ | 14,253,806 |  
|                                                                        |  |             |        |                          |   |                  |  |   |                                            |   |  |               |         |   |                          |   |         |   |  |   |            |  

Note 7. Stock Options

The Companys stockholders approved the Banks Stock Option Plan on December 8, 1997. The stock option plan provides for the issuance of up to 21,707 stock options to certain officers and directors in the form of incentive
stock options or non-incentive stock options. No options have been granted since December 8, 1997.

At December 31, 2006 and 2005, 13,604 options
have been granted at an exercise price of $18.50, of which 13,604 options are fully vested and therefore currently exercisable. A summary of the changes in the Companys options during the six months ended December 31, 2006 and 2005 is
presented below:



|                                                    |  |        |  |        |  
|--------------------------------------------------- |  | ------ |  | ------ | -
|                                                    |  | 2006   |  | 2005   |  
|Stock options outstanding at beginning of the year  |  | 13,604 |  | 14,573 |  
|Granted                                             |  |       |  |       |  
|Exercised                                           |  |       |  | (969   | )
|Terminated                                          |  |       |  |       |  
|                                                    |  |        |  |        |  
|Stock options outstanding at the end of the quarter |  | 13,604 |  | 13,604 |  
|                                                    |  |        |  |        |  
|Stock options exercisable at the end of the quarter |  | 13,604 |  | 13,604 |  
|                                                    |  |        |  |        |  



7



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##### Table of Contents

Note 8. Capital Securities

On July 10, 2006, Ashe Lane Capital Trust (the Trust), a Delaware business trust formed by the Company, completed the sale of $5.0 million of floating rate capital securities (liquidation amount of $1,000 per security) in a
private placement as part of a pooled securities transaction (Capital Securities). The Trust also issued common securities to the Company and used the net proceeds from the offering to purchase a like amount of floating rate Junior
Subordinated Deferrable Interest Debentures (the Subordinated Debentures) of the Company.

The Capital Securities accrue and pay distributions
quarterly at a floating rate of LIBOR plus 150 basis points 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 quarterly
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 September 23, 2036 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
March 23, June 23, September 23 and December 23 on or after September 23, 2011 at the redemption price.

The Company
paid off $5.0 million of 10.25% fixed rate Capital Securities on July 25, 2006. The Company paid an early redemption cost of $384,375. This amount was expensed during the six months ended December 31, 2006.

Note 9. Impaired Loans

SFAS No. 114, Accounting by
Creditors for Impairment of a Loan, as amended by SAFS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosure, requires that the Company establish specific allowance on impaired loans and
disclosure of the Banks method of accounting for interest income on impaired loans. The Company considers all loans delinquent more than 90 days to be impaired and such loans amounted to $3,102,283 and $660,208 at December 31, 2006 and
December 31, 2005, respectively. The impaired loans at December 31, 2006 are primarily collateral dependent and management has determined that the underlying collateral value is less then the carrying amount of the loans. As a result, the
Company has established a $220,000 specific allowance for these loans as of December 31, 2006. The Company did not establish a specific allowance for the impaired loans at December 31, 2005. The Company established reserves for
uncollectible interest totaling $61,219 at December 31, 2006 and did not establish a reserve for uncollectible interest at December 31, 2005.

The effect of not recognizing interest income on non accrual loans in accordance with the original terms totaled approximately $170,555 and $115,364 during the quarters ended December 31, 2006 and 2005, respectively. Interest income
actually recognized on a cash basis on impaired loans during the quarters ended December 31, 2006 and 2005 was $28,710 and $4,876, respectively.



8



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##### Table of Contents

Note 10. Segment Reporting

The Company has additional reportable segments: AF Bank and AF Insurance Services, 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. provides insurance services. Information about reportable segments, and reconciliation of such information to the consolidated financial statements as of and for the three and six
months ended December 31, 2006 and December 31, 2005 is as follows (dollars in thousands):



|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|------------------------------------ |  | ---------------- | ---- | - | ------- | - | ------------------------- |  | - | ------------------------ | - |  | ------------------ | ---- | - |  | - | -------
|Three Months Ended December 31, 2006 |  | AFFinancialGroup |      |   | AF Bank |   | AFInsuranceServices, Inc. |  |   | Inter-segmentElimination |   |  | ConsolidatedTotals
|Interest income                      |  | $                |     |   |         | $ | 3,995                     |  | $ |                         |   |  | $                  | (1   | ) |  | $ | 3,994  
|Interest expense                     |  |                  | 93   |   |         |   | 1,959                     |  |   | 11                       |   |  |                    | (1   | ) |  |   | 2,062  
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income                  |  |                  | (93  | ) |         |   | 2,036                     |  |   | (11                      | ) |  |                    |     |   |  |   | 1,932  
|Provision for loan losses            |  |                  |     |   |         |   | 216                       |  |   |                         |   |  |                    |     |   |  |   | 216    
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income after provision  |  |                  | (93  | ) |         |   | 1,820                     |  |   | (11                      | ) |  |                    |     |   |  |   | 1,716  
|Non-interest income                  |  |                  |     |   |         |   | 533                       |  |   | 634                      |   |  |                    | (42  | ) |  |   | 1,125  
|Non-interest expense                 |  |                  | 17   |   |         |   | 1,932                     |  |   | 547                      |   |  |                    | (42  | ) |  |   | 2,454  
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Income (loss) before income taxes    |  |                  | (110 | ) |         |   | 421                       |  |   | 76                       |   |  |                    |     |   |  |   | 387    
|Income taxes                         |  |                  | (35  | ) |         |   | 133                       |  |   | 29                       |   |  |                    |     |   |  |   | 127    
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net income (loss)                    |  | $                | (75  | ) |         | $ | 288                       |  | $ | 47                       |   |  | $                  |     |   |  | $ | 260    
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Assets                               |  | $                | 330  |   |         | $ | 246,248                   |  | $ | 2,142                    |   |  | $                  | (712 | ) |  | $ | 248,008
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|                                     |  |                  |      |   |        
|Three Months Ended December 31, 2005 |  | AFFinancialGroup |      |   | AF Bank |   | AFInsuranceServices, Inc. |  |   | Inter-segmentElimination |   |  | ConsolidatedTotals
|Interest income                      |  | $                |     |   |         | $ | 3,340                     |  | $ |                         |   |  | $                  | (1   | ) |  | $ | 3,339  
|Interest expense                     |  |                  | 133  |   |         |   | 1,229                     |  |   | 14                       |   |  |                    | (1   | ) |  |   | 1,375  
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income                  |  |                  | (133 | ) |         |   | 2,111                     |  |   | (14                      | ) |  |                    |     |   |  |   | 1,964  
|Provision for loan losses            |  |                  |     |   |         |   | 39                        |  |   |                         |   |  |                    |     |   |  |   | 39     
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income after provision  |  |                  | (133 | ) |         |   | 2,072                     |  |   | (14                      | ) |  |                    |     |   |  |   | 1,925  
|Non-interest income                  |  |                  |     |   |         |   | 431                       |  |   | 611                      |   |  |                    | (41  | ) |  |   | 1,001  
|Non-interest expense                 |  |                  | 38   |   |         |   | 1,976                     |  |   | 559                      |   |  |                    | (41  | ) |  |   | 2,532  
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Income (loss) before income taxes    |  |                  | (171 | ) |         |   | 527                       |  |   | 38                       |   |  |                    |     |   |  |   | 394    
|Income taxes                         |  |                  | (55  | ) |         |   | 206                       |  |   | 16                       |   |  |                    |     |   |  |   | 167    
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net income (loss)                    |  | $                | (116 | ) |         | $ | 321                       |  | $ | 22                       |   |  | $                  |     |   |  | $ | 227    
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Assets                               |  | $                | 371  |   |         | $ | 217,505                   |  | $ | 2,239                    |   |  | $                  | (449 | ) |  | $ | 219,666
|                                     |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        



9



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##### Table of Contents

|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|----------------------------------- |  | ---------------- | ---- | - | ------- | - | ------------------------- |  | - | ------------------------ | - |  | ------------------ | ---- | - |  | - | -------
|Six Months Ended December 31, 2006  |  | AFFinancialGroup |      |   | AF Bank |   | AFInsuranceServices, Inc. |  |   | Inter-segmentElimination |   |  | ConsolidatedTotals
|Interest income                     |  | $                |     |   |         | $ | 7,800                     |  | $ |                         |   |  | $                  | (2   | ) |  | $ | 7,798  
|Interest expense                    |  |                  | 600  |   |         |   | 3,586                     |  |   | 23                       |   |  |                    | (2   | ) |  |   | 4,207  
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income                 |  |                  | (600 | ) |         |   | 4,214                     |  |   | (23                      | ) |  |                    |     |   |  |   | 3,591  
|Provision for loan losses           |  |                  |     |   |         |   | 245                       |  |   |                         |   |  |                    |     |   |  |   | 245    
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income after provision |  |                  | (600 | ) |         |   | 3,969                     |  |   | (23                      | ) |  |                    |     |   |  |   | 3,346  
|Non-interest income                 |  |                  |     |   |         |   | 1,021                     |  |   | 1,308                    |   |  |                    | (97  | ) |  |   | 2,232  
|Non-interest expense                |  |                  | 34   |   |         |   | 3,789                     |  |   | 1,081                    |   |  |                    | (97  | ) |  |   | 4,807  
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Income (loss) before income taxes   |  |                  | (634 | ) |         |   | 1,201                     |  |   | 204                      |   |  |                    |     |   |  |   | 771    
|Income taxes                        |  |                  | (202 | ) |         |   | 437                       |  |   | 79                       |   |  |                    |     |   |  |   | 314    
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net income (loss)                   |  | $                | (432 | ) |         | $ | 764                       |  | $ | 125                      |   |  | $                  |     |   |  | $ | 457    
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Assets                              |  | $                | 330  |   |         | $ | 246,248                   |  | $ | 2,142                    |   |  | $                  | (712 | ) |  | $ | 248,008
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|                                    |  |                  |      |   |        
|Six Months Ended December 31, 2005  |  | AFFinancialGroup |      |   | AF Bank |   | AFInsuranceServices, Inc. |  |   | Inter-segmentElimination |   |  | ConsolidatedTotals
|Interest income                     |  | $                |     |   |         | $ | 6,530                     |  | $ |                         |   |  | $                  | (3   | ) |  | $ | 6,527  
|Interest expense                    |  |                  | 266  |   |         |   | 2,399                     |  |   | 29                       |   |  |                    | (3   | ) |  |   | 2,691  
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income                 |  |                  | (266 | ) |         |   | 4,131                     |  |   | (29                      | ) |  |                    |     |   |  |   | 3,836  
|Provision for loan losses           |  |                  |     |   |         |   | 69                        |  |   |                         |   |  |                    |     |   |  |   | 69     
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net interest income after provision |  |                  | (266 | ) |         |   | 4,062                     |  |   | (29                      | ) |  |                    |     |   |  |   | 3,767  
|Non-interest income                 |  |                  |     |   |         |   | 883                       |  |   | 1,315                    |   |  |                    | (99  | ) |  |   | 2,099  
|Non-interest expense                |  |                  | 84   |   |         |   | 3,896                     |  |   | 1,165                    |   |  |                    | (99  | ) |  |   | 5,046  
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Income (loss) before income taxes   |  |                  | (350 | ) |         |   | 1,049                     |  |   | 121                      |   |  |                    |     |   |  |   | 820    
|Income taxes                        |  |                  | (112 | ) |         |   | 410                       |  |   | 48                       |   |  |                    |     |   |  |   | 346    
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Net income (loss)                   |  | $                | (238 | ) |         | $ | 639                       |  | $ | 73                       |   |  | $                  |     |   |  | $ | 474    
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        
|Assets                              |  | $                | 371  |   |         | $ | 217,505                   |  | $ | 2,239                    |   |  | $                  | (449 | ) |  | $ | 219,666
|                                    |  |                  |      |   |         |   |                           |  |   |                          |   |  |                    |      |   |  |   |        

Note 11. Reclassifications

Certain amounts in the December 2005 financial statements have been reclassified to conform to the December 2006 presentation. The reclassification had no effect on net income or stockholders equity, as
previously reported.



10



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##### Table of Contents

|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 national and regional, 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 (the Company) is a federally chartered thrift holding company that owns 100% of the common stock of AF Bank (the Bank), AF Insurance Services, Inc. (an independent insurance
agency) and Ashe Lane Capital Trust (a Delaware business trust). The Company has no operations and conducts no business of its own other than ownership of its subsidiaries. The Bank is a federally chartered stock savings bank which 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 uninsured investment products. In July 1997, we started offering traditional property and casualty,
life and health insurance products through AF Insurance Services, Inc., headquartered in West Jefferson, North Carolina and operating in Boone, Elkin, Jefferson, Lenoir, Sparta, West Jefferson and North Wilkesboro, North Carolina.

During the fourth quarter of the 2005 fiscal year, AF Financial Group dissolved the broker/dealer subsidiary, AF Brokerage, Inc. We continue to offer the same level of
service through a third party relationship that AF Bank has entered into with LaSalle Street Securities. This structure allows us to offer a full array of investment products, including fixed-rate and variable annuities and mutual funds while
reducing expenses associated with maintaining an independent broker/dealer registration. This third party relationship operates as a division of AF Bank under the name AF Investments.

On July 10, 2006, Ashe Lane Capital Trust, a Delaware business trust formed by the Company, completed the sale of $5.0 million of floating rate capital securities. The issuance was priced at LIBOR plus 150 basis
points. At approximately the same time the Company paid off the existing $5.0 million 10.25% fixed-rate capital securities. The Company had to pay a $384,375 early redemption penalty for paying off the 10.25% issuance. Management believes that the
Company will recapture the penalty amount within three years by recognizing a decrease in interest costs.

One initiative that management and the board of
directors believe is a focal point of our continued success is to develop methods and products to better serve our customers in order to maintain a loyal customer base. To accomplish this we are continuing to develop products and services that help
create a unique financial experience to make banking easier and more convenient for our customers. We started the process of improving customer service during the 2006 fiscal year by listening to our customers and learning what is important to them.
Below are just a few of the changes that we have implemented that we believe will provide our customers with a more convenient and enjoyable financial services experience.



| |  |  | Expanded hours;
| | - |  | ---------------



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| |  |  | Expanded ATM network;
| | - |  | ---------------------



| |  |  | Reserved parking for expectant parents;
| | - |  | ---------------------------------------



| |  |  | Branch remodeling projects;
| | - |  | ---------------------------



| |  |  | Coffee service in each branch location;
| | - |  | ---------------------------------------



| |  |  | Computer kiosks in branch lobby and;
| | - |  | ------------------------------------



| |  |  | Express drive-thru lane.
| | - |  | ------------------------

More ideas will be
implemented during the fiscal year 2007. We are excited about these changes and will continue to look for ways to provide unique and convenient financial services to our customers and potential customers.

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 80.6% 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 monetary actions by the Federal Reserve. 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. At December 31, 2006 we had approximately $73.4 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 on our loans priced at prime and our ability to move our deposit mix to less interest rate sensitive products has allowed us to increase our net interest margin. However, we believe that the stabilization of interest rates by the
Federal Reserve will have a more positive impact on our net income than continued rate hike adjustments.

Net income increased $33,056 to $259,995 for the
three months ended December 31, 2006 from $226,939 for the three months ended December 31, 2005. Net income decreased $16,604 for the six months ended December 31, 2006 to $457,696 for the six months ended December 31, 2006 from
$474,300 for the six months ended December 31, 2005. The changes in net income during the three and six month periods were primarily attributable to the early redemption penalty on trust preferred capital securities and an increase in the
provision for loan losses offset by an increase in non interest income and a decrease in noninterest expense.

There are a number of positive factors
during the six months ended December 31, 2006, which underscore our commitment to the long-term profitability and success of the Company:



| |  |  | An increase in net loans of $4.2 million or 2.2%;
| | - |  | -------------------------------------------------



| |  |  | An increase in savings deposits of $19.8 million or 11.2%, and
| | - |  | --------------------------------------------------------------



| |  |  | Asset growth of $18.7 million or 8.1%.
| | - |  | --------------------------------------



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Critical Accounting Policies and Estimates

The notes to our audited consolidated financial statements for the year ended June 30, 2006 included in the AF Financial Group 2006 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 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 regional
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.

All loans in the portfolio are assigned an allowance percentage requirement based on the type of underlying collateral and payment terms. Furthermore, loans are
evaluated individually and are assigned a credit grade using such factors as the borrowers cash flow, the value of the collateral and the strength of any guarantee. Loans identified as having weaknesses, or adverse credit grades, are assigned
a higher allowance percentage requirement than loans where no weaknesses are identified. We routinely monitor our loan portfolio to determine if a loan is deteriorating, therefore requiring a higher allowance requirement. Factors we consider are
payment status, collateral value and the probability of collecting scheduled principal and interest payments when due.

The allowance percentage
requirement changes from period to period as a result of a number of factors, including: changes in the mix of types of loans; changes in credit grades within the portfolio, which arise from a deterioration or an improvement in the performance of
the borrower; changes in the historical loss percentages and delinquency trends; current charge offs and recoveries; and changes in the amounts of loans outstanding.

Although we believe that we have established and maintained the ALL at adequate 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



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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

We evaluate 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. Goodwill is recorded in our
reportable segment, AF Insurance Services, Inc.

Comparison of Financial Condition at December 31, 2006 and June 30, 2006:

Total assets increased by $18.7 million, or 8.1%, to $248.0 million at December 31, 2006 from $229.4 million at June 30, 2006. The increase in assets was
primarily the result of an increase of $14.5 million, or 418.5%, in securities available for sale, an increase of $4.2 million, or 2.2%, in net loans receivable and a increase of $1.1 million in loans held for sale partially offset by a decrease of
$1.7 million in interest bearing deposits from June 30, 2006 to December 31, 2006.

Securities available for sale increased $14.5 million, or
418.5%, to $17.9 million at December 31, 2006 from $3.5 million at June 30, 2006. This increase was due to the purchase of investments totaling $14.6 million and the $28,486 increase in market value partially offset by the $124,600
proceeds received from principal payments on mortgage backed securities. The investments purchased were investment grade municipal bonds. The municipal bonds are general obligation bonds and the interest income is exempt for federal income taxes.
Management decided to purchase the municipal bonds due to the interest rate spread available on the bonds versus the current and predicted cost of funds. At December 31, 2006, our investment portfolio had $2,262 in net unrealized gains as
compared to net unrealized losses of $26,224 at June 30, 2006.

Net loans increased $4.2 million, or 2.2%, to $198.1 million at December 31, 2006
from $193.9 million at June 30, 2006. The increase in net loans receivable is primarily due to the increases in commercial loans during the six months ended December 31, 2006. Commercial loans increased $8.4 million from $19.2 million at
June 30, 2006 to $27.6 million at December 31, 2006. The increase in commercial loans is the result of expanding relationships with existing customers. The increase in commercial loans was partially offset by a decrease in total mortgage
loans.



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The following table sets forth the composition of our mortgage and other loan portfolios in dollar amounts and
percentages at the dates indicated.



|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|--------------------------------------------- |  | ---------------------- | ------- | ---------- | --------------- | - | ------ | - | ---------- |  | ------ | -
|                                              |  | At December 31, 2006   |         |            | At June 30,2006 |  
|                                              |  | Amount                 |         | % of Total |                 |   | Amount |   | % of Total | 
|                                              |  | (Dollars in thousands) |        
|Mortgage loans:                               |  |                        |         |            |                 |   |        |   |            |  |        |  
|One-to four-family                            |  | $                      | 98,313  |            | 49.62           | % |        | $ | 100,198    |  | 51.68  | %
|Multi-family                                  |  |                        | 3,643   |            | 1.84            | % |        |   | 4,179      |  | 2.15   | %
|Non-residential                               |  |                        | 28,400  |            | 14.33           | % |        |   | 29,779     |  | 15.35  | %
|Land                                          |  |                        | 20,074  |            | 10.13           | % |        |   | 17,929     |  | 9.24   | %
|Construction                                  |  |                        | 11,072  |            | 5.59            | % |        |   | 14,660     |  | 7.56   | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|Total mortgage loans                          |  | $                      | 161,502 |            | 81.51           | % |        | $ | 166,745    |  | 85.98  | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|Other loans:                                  |  |                        |         |            |                 |   |        |   |            |  |        |  
|Commercial                                    |  | $                      | 27,612  |            | 13.93           | % |        | $ | 19,221     |  | 9.91   | %
|Consumer loans                                |  |                        | 11,051  |            | 5.58            | % |        |   | 9,782      |  | 5.04   | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|Total other loans                             |  | $                      | 38,663  |            | 19.51           | % |        | $ | 29,003     |  | 14.95  | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|Gross loans                                   |  | $                      | 200,165 |            | 101.02          | % |        | $ | 195,748    |  | 100.93 | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|Less:                                         |  |                        |         |            |                 |   |        |   |            |  |        |  
|Unearned discounts and net deferred loan fees |  | $                      | 233     |            | 0.12            | % |        | $ | 241        |  | 0.12   | %
|Allowance for loan losses                     |  |                        | 1,788   |            | 0.90            | % |        |   | 1,568      |  | 0.81   | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|                                              |  |                        | 2,021   |            | 1.02            | % |        |   | 1,809      |  | 0.93   | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  
|Loans, net                                    |  | $                      | 198,144 |            | 100.00          | % |        | $ | 193,939    |  | 100.00 | %
|                                              |  |                        |         |            |                 |   |        |   |            |  |        |  

Savings deposits increased by $19.8 million, or 11.2%, from $177.0 million at June 30, 2006 to $196.9 million
at December 31, 2006. We believe that the increase in deposits is attributable to our continuing effort to increase balances in savings and transaction accounts and in smaller, stable certificates of deposits. We intend to further focus our
efforts in this area and to offer new products and services to increase lower cost core deposits.

Short-term borrowings decreased $501,217, or 10.2%, to
$4.4 million at December 31, 2006 from $4.9 million at June 30, 2006. Long-term borrowings decreased $106,379, or 0.4%, to $29.8 million at December 31, 2006 from $29.9 million at June 30, 2006. The decrease in long and
short-term borrowings was due to the Company using part of the proceeds from the $19.4 million increase in savings deposits to repay the borrowings.

The
Banks level of non-performing loans, defined as loans past due 90 days or more, increased to $3,102,283, or 1.3% of total assets, at December 31, 2006 compared to $660,208, or 0.30% of total assets, at December 31, 2005. The increase
in the level of non-performing loans is primarily due to nonresidential mortgage loans and land loans that were over 90 days delinquent as of December 31, 2006. Management believes that the Bank has impairment of approximately $220,000 on these
loans. A $220,000 specific reserve has been established for these loans and is included in total allowance for loan losses. The Bank recognized total charge-offs of $40,887 during the six months ended December 31, 2006 compared to total
charge-offs of $49,695 during the six months ended December 31, 2005. Total recoveries decreased to $16,587 for the six months ended December 31, 2006 from $24,815 for the six months ended December 31, 2005. The Bank recognized net
charge-offs of approximately $24,300 during the six months ended December 31, 2006 compared to net charge-offs of $24,880 for the six months ended December 31, 2005.

The ALL to total non-performing assets totaled 44.58% at December 31, 2006 compared to 139.09% at June 30, 2006. The ALL to total non-performing loans totaled 57.64% at December 31, 2006 compared to
716.98% at June 30, 2006. These decreases were primarily attributable to an increase in the level of non performing loans during the six months ended December 31, 2006. Non-performing loans totaled $218,694



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at June 30, 2006 compared to $3,102,283 at December 31, 2006. Due to the increase in non-performing loans and the change in the mix of loans and
based upon a detailed analysis of the overall quality of our loan portfolio, we made a $244,500 provision to the ALL during the six month period ended December 31, 2006. The ALL to total loans totaled 0.89% at December 31, 2006 compared to
0.80% at June 30, 2006.

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



|                                                                          |  |                                          |         |   |                                          |   |         |  
|------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | ---------------------------------------- | - | ------- | -
|                                                                          |  | For theSix MonthsEnded December 31, 2006 |         |   | For theSix MonthsEnded December 31, 2005 |  
|                                                                          |  | (Dollars in thousands)                   |        
|Balance at beginning of year                                              |  | $                                        | 1,568   |   |                                          | $ | 1,385   |  
|Provision for loan losses                                                 |  |                                          | 245     |   |                                          |   | 69      |  
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Charge-offs:                                                              |  |                                          |         |   |                                          |   |         |  
|One- to four-family residential                                           |  |                                          | (4      | ) |                                          |   | (28     | )
|Multi-family residential                                                  |  |                                          |        |   |                                          |   |        |  
|Non-residential and land                                                  |  |                                          |        |   |                                          |   |        |  
|Construction                                                              |  |                                          |        |   |                                          |   |        |  
|Commercial                                                                |  |                                          |        |   |                                          |   |        |  
|Consumer loans                                                            |  |                                          | (37     | ) |                                          |   | (21     | )
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Total charge-offs                                                         |  |                                          | (41     | ) |                                          |   | (49     | )
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Recoveries:                                                               |  |                                          |         |   |                                          |   |         |  
|One- to four-family residential                                           |  |                                          | 6       |   |                                          |   | 2       |  
|Multi-family residential                                                  |  |                                          |        |   |                                          |   |        |  
|Non-residential and land                                                  |  |                                          |        |   |                                          |   |        |  
|Construction                                                              |  |                                          |        |   |                                          |   |        |  
|Commercial                                                                |  |                                          |        |   |                                          |   |        |  
|Consumer loans                                                            |  |                                          | 10      |   |                                          |   | 23      |  
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Total recoveries                                                          |  |                                          | 16      |   |                                          |   | 25      |  
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Balance at end of period                                                  |  | $                                        | 1,788   |   |                                          | $ | 1,430   |  
|                                                                          |  |                                          |         |   |                                          |   |         |  
|                                                                          |  |                                         
|                                                                          |  | At December 31,2006                      |         |   | At June 30,2006                          |  
|Total loans outstanding                                                   |  | $                                        | 200,165 |   |                                          | $ | 195,748 |  
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Allowance for loan losses                                                 |  | $                                        | 1,788   |   |                                          | $ | 1,568   |  
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Allowance for loan losses to total loans at end of period                 |  |                                          | 0.89    | % |                                          |   | 0.80    | %
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Allowance for loan losses to total non-performing assets at end of period |  |                                          | 44.58   | % |                                          |   | 139.09  | %
|                                                                          |  |                                          |         |   |                                          |   |         |  
|Allowance for loan losses to total non-performing loans at end of period  |  |                                          | 57.64   | % |                                          |   | 716.98  | %
|                                                                          |  |                                          |         |   |                                          |   |         |  



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Comparison of Operating Results for the Three and Six Months Ended December 31, 2006 and 2005:

Net income for the three-month period ended December 31, 2006 increased $33,056 to $259,995 compared to net income of $226,939 during the same period in 2005. Net
income for the six-month period ended December 31, 2006 decreased $16,604 to $457,696 for the six months ended December 31, 2006 compared to net income of $474,300 during the same period in 2005. The change in net income during the three
month period was primarily attributable an increase in the provision for loan losses offset by an increase in non interest income and a decrease in noninterest expense. The changes in net income during the six month period was attributable to the
early redemption penalty on trust preferred capital securities and an increase in the provision for loan losses offset by an increase in non interest income and a decrease in noninterest expense.

Interest Income. Interest income increased by $654,988, or 19.6%, from $3,339,296 for the three-month period ended December 31, 2005 to $3,994,284 for the
three-month period ended December 31, 2006. Interest income increased by $1,269,948, or 19.5%, from $6,527,692 for the six-month period ended December 31, 2005 to $7,797,640 for the six-month period ended December 31, 2006. Interest
income from loans increased $481,829, or 14.9%, from $3,242,667 for the three-month period ended December 31, 2005 to $3,724,496 for the three-month period ended December 31, 2006. Interest income from loans increased $1,066,540, or 16.8%,
from $6,339,135 for the six months ended December 31, 2005 to $7,405,675 for the six months ended December 31, 2006. The increases in interest income from loans for the three and six month periods were attributable to an increase in the
weighted average rate on portfolio loans and an increase in the outstanding loan balances. The weighted average rate on portfolio loans increased .66% from 6.81% at December 31, 2005 to 7.47% at December 31, 2006, primarily due to the 100
basis point interest rate hike by the Federal Reserve during the twelve months ended December 31, 2006. Total loans increased $15.2 million from $185.0 million at December 31, 2005 to $200.2 million at December 31, 2006.

Interest Expense. Interest expense increased by $687,029, or 50.0%, to $2,062,137 for the three-month period ended December 31, 2006 from $1,375,108 for
the three-months ended December 31, 2005. Interest expense increased by $1,516,364, or 56.4%, to $4,207,307 for the six-month period ended December 31, 2006 from $2,690,943 for the six-month period ended December 31, 2005. The
increase in interest expense for the three-month period ended December 31, 2006 is primarily due to an increase in interest expense on savings deposits. The increase in interest expense for the six-month period ended December 31, 2006 is
primarily attributable to an early redemption penalty on trust preferred capital securities and an increase in interest expense on savings deposits.

Interest expense on savings deposits increased $585,788 from $921,158 for the three months ended December 31, 2005 to $1,506,946 for the three months ended December 31, 2006. Interest expense on savings deposits increased $984,650
from $1,777,927 for the six months ended December 31, 2005 to $2,762,577 for the six months ended December 31, 2006. These increases were primarily attributable to the increase in savings deposits and to an increase of the weighted average
rate paid on deposits. Savings deposits increased $26.0 million from $170.9 million at December 31, 2005 to $196.9 million at December 31, 2006. We believe that the increase in deposits is attributable to our continuing effort to increase
balances in savings and transaction accounts and in smaller, stable certificates of deposits. The weighted average rate paid on savings deposits increased .91% from 2.34% at December 31, 2005 to 3.25% at December 31, 2006.

During the six-month period ended December 31, 2006, the Company paid off a $5.0 million 10.25% fixed-rate trust preferred capital securities issuance and paid a
$384,375 early redemption penalty. This penalty was expensed during the six months ended December 31, 2006.

Net Interest Income. Net interest
income decreased by $32,041, or 1.6%, from $1,964,188 for the three-month period ended December 31, 2005 to $1,932,147 for the three-month period ended December 31, 2006. Net interest income decreased by $246,416, or 6.4%, from $3,836,749
for the six-month period ended December 31, 2005 to $3,590,333 for the six-month period ended December 31, 2006. The decrease in net



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interest income during the three-month period ended December 31, 2006 is the result of an increase in interest expense, partially offset by the increase
in the weighted average interest rate earned on the loan portfolio and an increase in outstanding loan balances. The decrease in net interest income during the six-month period ended December 31, 2006 is the result of the early redemption
penalty on trust preferred capital securities and an increase in interest expense, partially offset by the increase in the weighted average interest rate earned on the loan portfolio and an increase in outstanding loan balances. 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. The
provision for loan losses charged to earnings is an amount sufficient to bring the allowance for loan losses to an estimated balance considered 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 allowance for loan losses changes from period to period as a result of a number of factors, including: changes in the mix of types of loans; changes in credit grades within the
portfolio, which arise from a deterioration or an improvement in the performance of the borrower; changes in the historical loss percentages and delinquency trends; current charge-offs and recoveries; and changes in the amounts of loans outstanding.
The net change in all of the components results in the provision for loan losses. We had no significant changes in any of the factors mentioned above during the six months ended December 31, 2006.

All loans in the portfolio are assigned an allowance percentage requirement based on the type of underlying collateral and payment terms. Furthermore, loans are
evaluated individually and are assigned a credit grade using such factors as the borrowers cash flow, the value of the collateral and the strength of any guarantee. Loans identified as having weaknesses, or adverse credit grades, are assigned
a higher allowance percentage requirement than loans where no weaknesses are identified. We routinely monitor our loan portfolio to determine if a loan is deteriorating, therefore requiring a higher allowance requirement. Factors we consider are
payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Although we believe that we have established and maintained the ALL at adequate levels, future adjustments may be necessary if
economic, real estate and other conditions differ substantially from the current operating environment.

We made a $216,000 provision to the ALL during the
three-month period ended December 31, 2006, compared to a provision for loan losses of $39,000 made during the three-month period ended December 31, 2005. We made a $244,500 provision to the ALL during the six-month period ended
December 31, 2006, compared to a provision for loan losses of $69,000 made during the six-month period ended December 31, 2005. As mentioned above, during the six-month period ended December 31, 2006 we had net charge-offs of $24,300.
We made additional provisions to the ALL during the three and six month periods ended December 31, 2006 based upon an analysis of the quality of our loan portfolio. Management discovered during a review of our nonperforming loans five loans
where the loan amount exceeded the fair value of the collateral. We determined that we had impairment on these loans of $220,000 and a specific reserve has been established and is included in total allowance for loan losses. Future loan loss
provision requirements are uncertain. At December 31, 2006, our level of ALL amounted to $1,788,187, or 0.89% of total loans, as compared to $1,567,988 of ALL, or 0.80% of total loans at June 30, 2006, which we believe is adequate to
absorb any probable losses inherent in our loan portfolio.

Noninterest Income. Noninterest income increased by $123,737, or 12.4%, from $1,001,435
for the three- month period ended December 31, 2005 to $1,125,172 for the three months ended December 31, 2006. Noninterest income increased $133,046, or 6.3%, from $2,099,150 for the six-month period ended December 31, 2005 to
$2,232,196 for the six-month period ended December 31, 2006. The increases in noninterest income during the three and six month periods ended December 31, 2006 were primarily attributable to increases in commission income on noninsured
investment sales and rental income. The increase in commission income from investments is due to a sales focus on larger markets where we have a banking presence. The increase in rental income is due to the leasing of the available office space in
the Boone Financial Center during the fiscal year ended June 30, 2006. The leases have terms ranging from three to five years.



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Non-Interest Expense. Non-interest expense decreased by $78,017, or 3.1%, from $2,532,160 for the three months
ended December 31, 2005 to $2,454,143 for the three months ended December 31, 2006. Non-interest expense decreased by $239,136, or 4.7%, from $5,045,774 for the six months ended December 31, 2005 to $4,806,638 for the six months ended
December 31, 2006. The decreases in non-interest expense for the three and six month periods ended December 31, 2006 is primarily attributable to a decrease in computer processing charges. Computer processing charges decreased $133,038, or
56.4%, from $235,857 for the three months ended December 31, 2005 to $102,819 for the three months ended December 31, 2006. Computer processing charges decreased $200,604, or 47.3%, from $424,205 for the six months ended December 31,
2005 to $223,601 for the six months ended December 31, 2006. These decreases are the result of the core data processing conversion that occurred during the year ending June 30, 2006. Since this conversion we have been able to reduce the
fees paid for core data processing while improving the speed and reliability of the system.

Income Taxes.Income taxes resulted from applying
normal, expected tax rates on income earned during the three and six months ended December 31, 2006 and 2005. The income tax expense was $127,181 for the three months ended December 31, 2006 compared to the income tax expense of $167,524
for the three months ended December 31, 2005. The income tax expense was $313,695 for the six months ended December 31, 2006 compared to the income tax expense of $346,825 for the six months ended December 31, 2005. The effective tax
rate was higher than statutory tax rates, resulting primarily from the fact that North Carolina corporations may not file consolidated income tax returns. This has 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. The effective tax rate for the three and six month periods ended
December 31, 2006 were lower then the effective tax rate for the three and six month periods ended December 31, 2005 due to the purchase of $14.6 million in municipal bonds during the six-month period ended December 31, 2006. The
municipal bonds are general obligation bonds and the interest income is exempt for federal income taxes thus reducing the overall effective tax rate.

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.

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 FHLB and use the wholesale deposit markets. At December 31, 2006, we had borrowings of $28.1 million from the FHLB. The Bank also maintains borrowing agreements with the FRB of
Richmond, Virginia.



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The Company anticipates that it will have sufficient funds available to meet its current loan origination commitments.
Certificates of deposit scheduled to mature in less than one year totaled $103.9 million at December 31, 2006. Based upon historical experience, we believe that a significant portion of such deposits will remain with the Bank.

As of December 31, 2006, cash and cash equivalents, a significant source of liquidity, totaled $9.8 million. The OTS 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. We do not anticipate any financial or insurance acquisitions at this time.

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 are material to investors.

New Accounting Pronouncements:

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain
Hybrid Financial Instrumentsan amendment of FASB Statements No. 133 and 140. This Statement amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and SFAS No. 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in
Securitized Financial Assets. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entitys first fiscal year that begins after September 15, 2006. We do not believe that the
adoption of SFAS No. 155 will have a material impact on our financial position, results of operations and cash flows.

In March 2006, the FASB issued
SFAS No. 156, Accounting for Servicing of Financial Assetsan amendment of FASB Statement No. 140. This Statement amends FASB No. 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it
undertakes an obligation to service a financial asset by entering into a servicing contract; requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable; permits an entity to
choose its subsequent measurement methods for each class of separately recognized servicing assets and servicing liabilities; at its initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities by
entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement 115, provided that the available-for-sale securities are identified in some manner as offsetting the
entitys exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value; and requires separate presentation of servicing assets and servicing liabilities subsequently
measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. An entity should adopt SFAS No. 156 as of the beginning of its first fiscal year
that begins after September 15, 2006. We do not believe the adoption of SFAS No. 156 will have a material impact on our financial position, results of operations and cash flows.



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In June 2006, the FASB issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income
Taxes,an interpretation of FASB Statement No. 109. FIN 48 addresses the recognition and measurement of certain tax positions taken in the financial statements of a business enterprise. It also includes certain financial statement
disclosures around uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have not yet evaluated the impact of FIN 48 on our consolidated financial statements.

In September 2006, the FASB issued SFAS 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principals (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements. Accordingly, this Statement does not
require any new fair value measurements. However, for some entities, the application of this Statement will change current practice. The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007
and interim periods within those years. We do not expect the adoption of SFAS 157 to have a material impact on our financial statements.

In September
2006, the FASB issued SFAS 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans. SFAS 158 requires an employer to recognize the overfunding or underfunding of a defined benefit postretirement plan as
an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This Statement also requires an employer to measure the funded status of
a plan as of the date of its year end statement of financial position, with limited exceptions. An employer with publicly traded equity securities is required to recognize the funded status of a defined postretirement plan and to provide the
required disclosures as of the end of the fiscal year ending after December 15, 2006. We do not expect the adoption of SFAS 158 to have a material impact on our financial statements.



|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 and that the controls and procedures ensure that such
information is accumulated and communicated to the Companys management as appropriate to allow timely decisions regarding required disclosure.

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 4. | Submission of Matters to a Vote of Security Holders
|------- | ---------------------------------------------------

The Company held its Annual Meeting of Shareholders (Meeting) on November 6, 2006. All of the proposals submitted to the shareholders at the Meeting were approved. The proposals submitted to shareholders and the tabulation
of votes for each proposal is as follows:



| | 1. | Election of three candidates to the Board of Directors, each to serve for a term of three years.
| | -- | ------------------------------------------------------------------------------------------------

The number of votes cast with respect to this matter was as follows:



|                  |  |         |  |          |  |                
|----------------- |  | ------- |  | -------- |  | ---------------
|Nominee           |  | For     |  | Withheld |  | BrokerNon-Votes
|Jan R. Caddell    |  | 956,215 |  | 8,030    |  | 86,559         
|Claudia L. Kelley |  | 959,385 |  | 4,860    |  | 86,559         
|Kenneth R. Greene |  | 959,435 |  | 4,810    |  | 86,559         

The following six directors were not up for reelection; however, they remain on the board to serve
their existing term: Wayne R. Burgess, Donald R. Moore, Jimmy D. Reeves, Jerry L. Roten, Michael M. Sherman and Robert E. Washburn. After the Annual Meeting, Karen Pennell Powell was appointed to the Board of Directors as reported in a Form 8-K
filed with the SEC on November 7, 2006.



| | 2. | Ratification of the appointment of Dixon Hughes PLLC as independent auditors for fiscal year ending June 30, 2007.
| | -- | ------------------------------------------------------------------------------------------------------------------

The number of votes cast with respect to this matter was as follows:



|        |  |         |  |           |  |                 
|------- |  | ------- |  | --------- |  | ----------------
|For     |  | Against |  | Abstained |  | Broker Non-Votes
|962,845 |  | 500     |  | 900       |  | 86,559          



|Item 6. | Exhibits
|------- | --------

Exhibits



|     |  |                                                                                                                                                                                                                                                                                               
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1  |  | Agreement and Plan of Reorganization dated September 15, 1997 by and among Ashe Federal Bank, AF Bankshares, Inc. and Ashe Interim Savings Bank (Incorporated by reference to Exhibit 2.1 of
the Registration Statement on Form 8-A, as filed with the SEC on June 16, 1998 (the Form 8-A)).
|     | 
|3.1  |  | Federal Stock Charter of the Company (Incorporated by reference to Exhibit 3.1 of the Form 8-A).                                                                                                                                                                                              
|     | 
|3.2  |  | Bylaws of the Company (Incorporated by reference to Exhibit 3.2 of the Form 8-A).                                                                                                                                                                                                             
|     | 
|4.1  |  | Common Stock Certificate of the Company (Incorporated by reference to Exhibit 4.3 of the Form 8-A).                                                                                                                                                                                           
|     | 
|10.1 |  | Employee Stock Ownership Plan of Ashe Federal Bank (Incorporated by reference to Exhibit 10.4 of the 1998 Form 10-KSB).                                                                                                                                                                       



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|     |  |                                                                                                                                                                                
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.2 |  | Amendment No. 1 to the Employee Stock Ownership Plan of AF Bank (Incorporated by reference to Exhibit 10.5 of the 2003 Form 10-KSB).                                           
|     | 
|10.3 |  | Amendment No. 2 to the Employee Stock Ownership Plan of AF Bank (Incorporated by reference to Exhibit 10.6 of the 2003 Form 10-KSB).                                           
|     | 
|10.4 |  | Amendment No. 3 to the Employee Stock Ownership Plan of AF Bank (Incorporated by reference to Exhibit 10.7 of the 2003 Form 10-KSB).                                           
|     | 
|10.5 |  | Amendment No. 4 to the Employee Stock Ownership Plan of AF Bank (Incorporated by reference to Exhibit 10.7 of the 2003 Form 10-KSB).                                           
|     | 
|10.6 |  | Salary Continuation Agreement between AF Bankshares, Inc. and Melanie Paisley Miller dated April 15, 2002 (Incorporated by reference to Exhibit 10.10 of the 2003 Form 10-KSB).
|     | 
|10.7 |  | Amended and Restated Retirement Plan for Board Members of AF Bank (Incorporated by reference to Exhibit 10 of the Form 8-K filed with the SEC on October 26, 2005).            
|     | 
|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 February 9, 2007 |  |  |  | By:                |  | /s/ Melanie Paisley Miller
|                       |  |  |  |                    |  |                            |  | Melanie Paisley Miller                                                 
|                       |  |  |  |                    |  |                            |  | Chief Financial Officer, Executive Vice President, Secretary, Treasurer



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