UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-K



ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934



For the fiscal year ended December 31, 2006

Commission File Number 000-22787



| |                                                        | 
| | ------------------------------------------------------ | 
| | FOUR OAKS FINCORP, INC.                                | 
| | (Exact name of registrant as specified in its charter) | 



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|North Carolina                                                 |  | 56-2028446                          
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer
Identification Number)



|                                              |  |           
|--------------------------------------------- |  | ----------
|6114 U.S. 301 South
Four Oaks, North Carolina |  | 27524     
|(Address of principal executive offices)      |  | (Zip Code)



Registrants telephone number, including area code:  (919) 963-2177



Securities registered under Section 12(b) of the Act: NONE

Securities registered under Section 12(g) of the Act:



Common Stock, par value $1.00 per share

(Title of Class)



Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.          YES  ̈  NO x



Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.          YES  ̈  NO x



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

SYES£NO



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

Form 10-K. S



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act:                         Large accelerated filer  £    Accelerated filer S    Non-accelerated filer £



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act):          £YES   SNO

$108,950,110

(Aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant based on the price at which the registrants Common Stock, par value $1.00 per share was sold on June 30, 2006)

5,606,677

(Number of shares of Common Stock, par value $1.00 per share, outstanding as of March 7, 2007)



Documents Incorporated by Reference

Where Incorporated

(1)  Proxy Statement for the 2007 Annual

Part III

Meeting of Shareholders to be held April 23, 2007















---





Forward Looking Information



Information set forth in this Annual Report on Form 10-K under the caption Business and Managements Discussion and Analysis of Financial Condition and Results of Operations contains various forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which statements represent our judgment concerning the future and are subject to business, economic and other risks and uncertainties, both known and unknown, that could cause our actual operating results and financial position to differ materially. Such forward looking statements can be identified by the use of forward looking terminology, such as may, will, expect, anticipate, estimate, or continue or the negative thereof or other variations thereof or comparable terminology.



We caution that any such forward looking statements are further qualified by important factors that could cause our actual operating results to differ materially from those in the forward looking statements, including, without limitation, the effects of future economic conditions, governmental fiscal and monetary policies, legislative and regulatory changes, the risks of changes in interest rates on the level and composition of deposits, the effects of competition from other financial institutions, the failure of assumptions underlying the establishment of the allowance for possible loan losses and the low trading volume of our common stock and the risks discussed in Item 1A. Risk Factors below.



Any forward looking statements contained in this annual report on Form 10-K are as of the date hereof and we undertake no duty to update them if our view changes later.  These forward looking statements should not be relied upon as representing our view as of any date subsequent to the date hereof.



2



---







PART I



Item 1 - Business.



Four Oaks Bank & Trust Company (referred to herein as the bank) was incorporated under the laws of the State of North Carolina in 1912. On February 5, 1997, the bank formed Four Oaks Fincorp, Inc. (referred to herein as the company; references herein to we, us and our refer to the company and its consolidated subsidiaries, unless the context otherwise requires) for the purpose of serving as a holding company for the bank. Our corporate offices and banking offices are located in eastern North Carolina in the counties of Johnston (our corporate headquarters), Wake, Sampson, Lee and Duplin counties. The Company has no significant assets other than cash, the capital stock of the bank and its membership interest in Four Oaks Mortgage Services, L.L.C., as well as, $1,015,000 in securities available for sale.



In addition, the Company has an interest in Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the Trust), for the sole purpose of issuing trust preferred securities.  The Trust is not consolidated with the financial statements of the Company pursuant to the provisions of Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities (revised December 2003)  an interpretation of ARB No. 51 (FIN 46R).

  

  The Company formed the Trust for the sole purpose of issuing $12.0 million of trust preferred securities (the Trust Preferred Securities). The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest  (the Debentures) issued by the Company and recorded in borrowings on the accompanying consolidated balance sheet.  The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%.  The dividends paid to holders of the Trust Preferred Securities, which are recorded as interest expense, are deductible for income tax purposes.



As of December 31, 2006, we had assets of $608.1 million, net loans outstanding of $456.2 million and deposits of $466.9 million.  We have enjoyed considerable growth over the past five (5) years as evidenced by a 102.9% increase in assets, a 120.2% increase in net loans outstanding, and a 98.1% increase in deposits since December 31, 2001.   We had net income of $7.0 million and $5.0 million and basic earnings per share of $1.27 and $0.92 for the years ended December 31, 2006 and 2005, respectively.   Net income of $4.4 million and basic earnings per share of $0.82 were recorded for the year ended December 31, 2004.



The bank continues to remain a community-focused bank engaging in general commercial banking business to the communities we serve in Johnston, Wake, Sampson, Lee and Duplin counties of North Carolina. The bank provides a full range of banking services, including such services as checking accounts; savings accounts; individual retirement accounts; NOW accounts; money market accounts; certificates of deposit; a student checking and savings program; loans for businesses, agriculture, real estate, personal uses, home improvement and automobiles; mortgage loans; equity lines of credit; credit cards; safe deposit boxes; electronic funds transfer services, including wire transfers; internet banking and bill pay services; telephone banking; cashiers checks; travelers check cards; and free notary services to all bank customers. The bank also provides financial services, offering a complete line of insurance and investment services, including financial strategies, mutual funds, annuities, insurance, stock brokerage, IRAs, discount brokerage services, employee benefit plans, 401(k)s and simplified employee pension plans.  In addition, the bank provides its customers access to automated teller machines (ATMs) through its own ATMs throughout its communities served as well as access to worldwide ATMs for cash withdrawals through the services of the Star, Cirrus, or Visa networks by using ATM or Visa check cards.  The Visa check cards may also be used at merchant locations worldwide through the Star, Cirrus, or Visa networks.  In 2003, the bank began issuing stored value cards which are marketed by independent sales organizations and provide access to funds through the Visa, Plus, Interlink, Mastercard, Maestro, Cirrus, and Star networks.  At present, the bank does not provide the services of a trust department.



The Company maintains a website at www.fouroaksbank.comwhere our periodic reports on Form 10-Q and 10-K and our current reports on Form 8-K are available under Investor Relations.   The Company is registered as a bank holding company with the Federal Reserve System.  The Company is a state-chartered member of the Federal Reserve System and the Federal Deposit Insurance Corporation (the FDIC) insures its deposits up to applicable limits.  Our corporate offices are located at 6114 US 301 South, Four Oaks, North Carolina, 27524.  Our common stock is traded on the OTC Bulletin Board under the symbol FOFN.





3



---





Our market area is concentrated in the eastern North Carolina counties of Johnston, Wake, Sampson, Lee and Duplin.  Johnston County is contiguous to Wake, Wayne, Wilson, Harnett, Sampson and Nash counties. Wake County is contiguous to Johnston, Durham, Harnett, Nash, Franklin, Granville and Chatham counties.  Sampson County is contiguous to Duplin, Pender, Bladen, Harnett, Cumberland, Johnston, and Wayne counties. Lee County is contiguous to Chatham, Moore and Harnett counties. Duplin County is contiguous to Pender, Sampson, Wayne, Lenoir, Jones and Onslow counties.



From its headquarters located in Four Oaks and its thirteen locations in Four Oaks, Clayton, Smithfield, Garner, Benson, Fuquay-Varina, Wallace, Holly Springs, Harrells, Sanford, and Zebulon, the bank serves a major portion of Johnston County, and part of Wake, Harnett, Duplin, Sampson and Lee counties.  Johnston County has a diverse economy and is not dependent on any one particular industry.  The leading industries in the area include retail trade, manufacturing, pharmaceuticals, government, services, construction, wholesale trade and agriculture. The population for Johnston County in 2005 was estimated in excess of 146,000.  As of June 2006, the bank ranked second in deposit market share for Johnston County at 26.4%.



In Four Oaks, the main office is located at 6144 US 301 South and an additional branch is located at 111 North Main Street. The bank also operates a branch office in Clayton at 102 East Main Street, two in Smithfield at 128 North Second Street, and 403 South Brightleaf Boulevard, one in Garner at 200 Glen Road, one in Benson at 200 East Church Street, one in Fuquay-Varina at 325 North Judd Parkway Northeast, one in Wallace at 406 East Main Street, one in Holly Springs at 101 West Center Street, one in Harrells at 590 Tomahawk Highway, one in Sanford at 830 Spring Lane, and one in Zebulon at 130 North Arendell Avenue.



The majority of the banks customers are individuals and small to medium-size businesses located in Johnston, Wake, Sampson, Lee and Duplin counties and surrounding areas. The deposits and loans are well diversified with no material concentration in a single industry or group of related industries. There are no seasonal factors that would have any material adverse effect on the banks business, and the bank does not rely on foreign sources of funds or income.



In an effort to offer a more diversified and competitive product line to better serve our customers and community, in 2003 we discontinued our provision of secondary market-type mortgages through the bank and, through a joint venture with Centex Corporation, formed Four Oaks Mortgage Company, L.P.  Since 2003, Four Oaks Mortgage Company, L.P. has provided secondary market-type mortgages and has been the vehicle through which all of our mortgage business is run.  Four Oaks Mortgage Company, L.P. is owned 49.99% by our wholly-owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly-owned indirect subsidiary of Centex Corporation.



Amounts spent on research activities relating to the development or improvement of services have been immaterial over the past two years. At December 31, 2006, the bank employed 156full time equivalent employees.   Our employees are extremely important to our continued success and the bank considers its relationship with its employees to be good.  Management continually seeks ways to improve upon their benefits and well being.



The following table sets forth certain of our financial data and ratios for the years ended December 31, 2006, 2005 and 2004 derived from our audited financial statements and notes. This information should be read in conjunction with and is qualified in its entirety by reference to the more detailed audited financial statements and notes thereto included in this report:



|                                                             |                               |         |      |   |         |  |   |        
|------------------------------------------------------------ | ----------------------------- | ------- | ---- | - | ------- |  | - | -------
|                                                             | 2006                          |         | 2005 |   | 2004   
|                                                             | (In thousands, except ratios)
|Net income                                                   | $                             | 7,017   |      | $ | 5,003   |  | $ | 4,375  
|Average equity capital accounts                              | $                             | 45,541  |      | $ | 39,613  |  | $ | 35,135 
|Ratio of net income to average equity capital accounts       |                               | 15.41%  |      |   | 12.63%  |  |   | 12.45% 
|Average daily total deposits                                 | $                             | 435,991 |      | $ | 355,214 |  | $ | 295,524
|Ratio of net income to average daily total deposits          |                               | 1.61%   |      |   | 1.41%   |  |   | 1.48%  
|                                                             |                               |         |      |   |         |  |   |        
|Average daily loans (gross)                                  | $                             | 426,768 |      | $ | 351,103 |  | $ | 298,783
|Ratio of average daily loans to average daily total deposits |                               | 97.88%  |      |   | 98.84%  |  |   | 101.10%





4



---







Competition



Commercial banking in North Carolina is extremely competitive due in large part to statewide branching. As a result, many commercial banks have branches located in several communities. The bank competes in its market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions. At June 2006, we operated branches in Johnston, Wake, Sampson, Duplin, Harnett and Lee counties, North Carolina. At that time in Johnston County, North Carolina, the banks primary market, there were a total of approximately $1.2 billion in deposits and 37 branches represented by the top eleven financial institutions in the county based on deposit share, all commercial banks. The bank operated six of the 37 branches with deposits of $321.3million, placing the bank second in the top eleven based on deposit share.  Many of the banks competitors have broader geographic markets and higher lending limits than those of the bank and are also able to provide more services and make greater use of media advertising.  Therefore, in our market area, the bank has significant competition for deposits and loans from other depository institutions.  Other financial institutions such as credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit with varying degrees of regulatory restrictions also compete in our market area. Additionally, credit unions have been permitted to expand their membership criteria and expand their loan services to include traditional bank services such as commercial lending creating a greater competitive disadvantage to tax-paying financial institutions.



The enactment of legislation authorizing interstate banking has caused great increases in the size and financial resources of some of the banks competitors. See Holding Company Regulation below for a description of this legislation.  In addition, as a result of interstate banking, out-of-state commercial banks may acquire North Carolina banks and heighten the competition among banks in North Carolina.



Although the competition in its market areas is expected to continue to be significant, the bank believes that it has certain competitive advantages that distinguish it from its competition. The bank believes that its primary competitive advantages are its strong local identity, its affiliation with the community and its emphasis on providing specialized services to small and medium-sized business enterprises, as well as professional and upper-income individuals. The bank offers customers modern, high-tech banking without forsaking community values such as prompt, personal service and friendliness. The bank offers many personalized services and attracts and retains customers by being responsive and sensitive to their individualized needs.  The bank also relies on goodwill and referrals from our shareholders and the banks satisfied customers, as well as traditional media, to attract new customers.  To enhance a positive image in the community, the bank supports and participates in local events and its officers and directors serve on boards of local civic and charitable organizations.



Governmental Regulation



Holding companies, banks and many of their non-bank affiliates are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules and regulations affecting us and the bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of the company or bank. Supervision, regulation and examination of the company and the bank by bank regulatory agencies is intended primarily for the protection of the banks depositors rather than the companys shareholders.

Holding Company Regulation



General.  Four Oaks Fincorp, Inc. is a holding company registered with the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (the BHCA). As such, we are subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The bank is also subject to the BHCA. The BHCA requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than five percent of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, (iii) acquiring all or substantially all of the assets of any bank or (iv) merging or consolidating with any other bank holding company.





5



---





The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. For example, banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, providing securities brokerage services, providing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities.



Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including us, provided the nature of the activity has been approved by the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company.



Financial Holding Companies.  The Gramm-Leach-Bliley Modernization Act of 1999 (the GLB), which was enacted on November 12, 1999, allows bank holding companies that meet certain new regulatory standards regarding management, capital and the Community Reinvestment Act of 1997 (the CRA), to engage in a broader range of non-banking activities than previously permissible, including insurance underwriting and making merchant banking investments in commercial and financial companies; allows insurers and other financial services companies to acquire banks; removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.



At the present time, we have elected to remain a bank holding company, and therefore we remain subject to the same regulatory framework as before the enactment of the GLB. However, the financial holding company structure created by the GLB permits insurance companies or securities firms operating under the financial holding company structure to acquire us, and, if we elect to become a financial holding company in the future, we could acquire insurance companies or securities firms.



In addition to creating the more flexible financial holding company structure, the GLB introduced several additional customer privacy protections that will apply to us and the bank. The GLBs privacy provisions require financial institutions to, among other things: (i) establish and annually disclose a privacy policy, (ii) give consumers the right to opt out of disclosures to nonaffiliated third parties, with certain exceptions, (iii) refuse to disclose consumer account information to third-party marketers and (iv) follow regulatory standards to protect the security and confidentiality of consumer information.



Pursuant to the GLBs rulemaking provisions, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision adopted regulations, establishing standards for safeguarding customer information. Such regulations provide financial institutions guidance in establishing and implementing administrative, technical and physical safeguards to protect the security, confidentiality and integrity of customer information.



Mergers and Acquisitions.  The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the IBBEA) permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five (5) years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than ten percent (10%) of the total amount of deposits of insured depository institutions in the U.S. and no more than thirty percent (30%) of such deposits in any state (or such lesser or greater amount set by state law).



In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997.  In 1995, the state of North Carolina opted in to such legislation. In addition, a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. As a result of North Carolina having opted-in, unrestricted interstate de novo branching is permitted in North Carolina.



6



---







Additional Restrictions and Oversight.  Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are also prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries.



The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve also regulates certain debt obligations, changes in control of bank holding companies and capital requirements.



Under the provisions of the North Carolina law, we are registered with and subject to supervision by the North Carolina Commissioner of Banks.



Capital Requirements.  The Federal Reserve has established risk-based capital guidelines for bank holding companies and state member banks. The minimum standard for the ratio of capital to risk-weighted assets (including certain off balance sheet obligations, such as standby letters of credit) is eight percent (8%). At least half of this capital must consist of common equity, retained earnings and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill items and certain other items (Tier 1 capital). The remainder (Tier 2 capital) may consist of mandatory convertible debt securities and a limited amount of other preferred stock, subordinated debt and loan loss reserves.



In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts (Leverage Ratio) equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent.



The guidelines also provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, will be expected to maintain strong capital ratios well above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a tangible Tier 1 Leverage Ratio (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised us of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to us.



As of December 31, 2006, we had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 12.87%, 14.02% and 10.29%, respectively, all in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions.



Dividends.  During 2006, we paid cash dividends of $.26per share on our common stock,a13.0%increase over 2005.  North Carolina banking law requires that dividends be paid out of retained earnings as determined pursuant to North Carolina General Statues Section 53-87. At present, the company has sufficient cash from its operations to pay cash dividends on its common stock.  In the past, we have received cash dividends from our bank and may continue to do so from time to time in the future as necessary for cash flow purposes.  Also, applicable federal banking law contains additional limitations and restrictions on the payment of dividends by a bank holding company.  Accordingly, shareholders receive dividends from us only to the extent that funds are available from our operations or the bank.  In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding companys capital needs, asset quality and overall financial condition.





7



---





USA Patriot Act of 2001.  Title III of the USA Patriot Act of 2001 contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the IMLAFA).  The anti-money laundering provisions of IMLAFA impose affirmative obligations on a broad range of financial institutions, including banks, brokers, and dealers.  Among other requirements, IMLAFA requires all financial institutions to establish anti-money laundering programs that include, at minimum, internal policies, procedures, and controls; specific designation of an anti-money laundering compliance officer; ongoing employee training programs; and an independent audit function to test the anti-money laundering program. IMLAFA requires financial institutions that establish, maintain, administer, or manage private banking accounts for non-United States persons or their representatives to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Additionally, IMLAFA provides for the Department of Treasury to issue minimum standards with respect to customer identification at the time new accounts are opened.  As of the date of this filing, we believe that IMLAFA has not had a material impact on the banks operations. The bank has established policies and procedures to ensure compliance with the IMLAFA, which are overseen by an Anti-Money Laundering Officer who was appointed by our Board of Directors.



Bank Regulation



The bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the North Carolina Commissioner of Banks and the Federal Reserve. The Federal Reserve and the North Carolina Commissioner of Banks regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations, and other similar corporate actions, and to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The Federal Reserve and the North Carolina Commissioner of Banks regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, issuances of securities, capital adequacy, loss reserves, and compliance with the CRA, as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are also subject to state usury laws and certain federal laws concerning interest rates.



The deposit accounts of the bank are insured by the Deposit Insurance Fund (the DIF) of the Federal Deposit Insurance Corporation (the FDIC) up to a maximum of one hundred thousand dollars ($100,000) per insured depositor, with the exception of retirement accounts, which were increased to $250,000 by the FDIC effective April 1, 2006.  Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies, and directives may be sanctioned for noncompliance. Civil and criminal proceedings may be instituted against any insured bank or any director, officer or employee of such bank for the violation of applicable laws and regulations, breaches of fiduciary duties or engaging in any unsafe or unsound practice. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose.



Under the North Carolina Business Corporation Act, we may not pay a dividend or distribution, if after giving it effect we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than our liabilities. All dividends paid by the bank are paid to us, the sole shareholder of the bank.  In general, our ability to pay cash dividends is dependent in part upon the amount of dividends paid to us by the bank. The ability of the bank to pay dividends to us is subject to statutory and regulatory restrictions on the payment of cash dividends, including the requirement under the North Carolina banking laws that cash dividends be paid only out of undivided profits and only if the bank has surplus of a specified level. The Federal Reserve also imposes limits on the bank's payment of dividends. The amount of future dividends paid to us by the bank will in general be a function of the profitability of the bank, which cannot be accurately estimated or assured. We expect the bank will continue to pay us dividends in the foreseeable future from time to time as needed to pay cash dividends to our shareholders.



Like us, the bank is required by federal regulations to maintain certain minimum capital levels. The levels required of the bank are the same as those required of us. At December 31, 2006, the bank had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 11.63%, 12.79% and 9.31%, respectively, in excess of the minimum requirements to be considered well-capitalized under prompt corrective action provisions.





8



---





The bank is subject to insurance assessments imposed by the FDIC, including a risk-based assessment schedule providing for annual assessment rates ranging from 5 to 43 cents per $100 in assessable deposits, applicable to institutions insured by the DIF. The FDIC may change the assessment schedule quarterly. The actual assessment to be paid by each insured institution is based on the institution's assessment risk classification, which focuses on whether the institution is considered well capitalized, adequately capitalized or under capitalized, as such terms are defined in the applicable federal regulations. Within each of these three risk classifications, each institution will be assigned to one of three subgroups based on supervisory risk factors. In particular, regulators will assess supervisory risk based on whether the institution is financially sound with only a few minor weaknesses (Subgroup A), whether it has weaknesses which, if not corrected, could result in an increased risk of loss to the DIF (Subgroup B) or whether such weaknesses pose a substantial probability of loss to the DIF unless effective corrective action is taken (Subgroup C). The FDIC also is authorized to impose one or more special assessments in an amount deemed necessary to enable repayment of amounts borrowed by the FDIC from the United States Treasury Department and, beginning in 1997, all banks are required to pay additional annual assessments as set by the Financing Corporation, which was established by the Competitive Equality Banking Act of 1987.



The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a prompt corrective action system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums.



A central feature of FDICIA is the requirement that the federal banking agencies take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: well capitalized, adequately capitalized, under capitalized, significantly undercapitalized, or critically undercapitalized. An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution.



Banks are also subject to the CRA, which requires the appropriate federal bank regulatory agency, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate-income neighborhoods. Each institution is assigned one of the following four ratings of its record in meeting community credit needs: outstanding, satisfactory, needs to improve or substantial noncompliance. The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application.



In addition, the GLBs CRA Sunshine Requirements call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements also must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require. This annual reporting requirement is effective for any agreements made after May 12, 2000.





9



---





Monetary Policy and Economic Controls



Both the company and the bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve Board, whose actions directly affect the money supply which, in turn, affects banks lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve Board regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits.



Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, or loan demand on our business and earnings or those of the bank. As a result, banks, including the bank, face a significant challenge to maintain acceptable net interest margins.





Our Executive Officers



The following table sets forth certain information with respect to our executive officers:





|                   |     |                     |                                                                                                                                                                                                                                                                                                              
|------------------ | --- | ------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Name               | Age | Year first employed | Positions and offices with Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company and business experience during past five (5) years                                                                                                                                                                     
|Ayden R. Lee, Jr.  | 58  | 1980                | Chief Executive Officer, President and Chairman of the Board of Directors of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company (effective January 1, 2007). Previously, Director of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company                                                      
|Clifton L. Painter | 57  | 1986                | Senior Executive Vice President, Chief Operating Officer of Four Oaks Fincorp, Inc. and Four Oaks  Bank & Trust Company                                                                                                                                                                                      
|Nancy S. Wise      | 51  | 1991                | Executive Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company.  Previously, Senior Vice President, Chief Financial Officer of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company                                                                   
|W. Leon Hiatt, III | 39  | 1994                | Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Chief Administrative Officer of Four Oaks Bank & Trust Company.  Previously,  Senior Vice President Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company,  Loan Administrator of Four Oaks Bank & Trust Company
|Jeff D. Pope       | 50  | 1991                | Executive Vice President of Four Oaks Fincorp, Inc. and Four Oaks Bank & Trust Company, Branch Administrator of Four Oaks Bank & Trust Company.  Previously, Senior Vice President, Loan Officer and Regional/Branch Administrator Four Oaks Bank and Trust Company                                          





10



---





Item 1A.

Risk Factors



Our Results Are Impacted by the Economic Conditions of Our Principal Operating Regions



The majority of our customers are individuals and small to medium-size businesses located in North Carolinas Johnston, Wake, Duplin, Sampson and Lee Counties and surrounding areas.  As a result of this geographic concentration, our results may correlate to the economic conditions in these areas.  Declines in these markets economic conditions may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations.



We Are Exposed to Risks in Connection with the Loans We Make



A significant source of risk for us arises from the possibility that loan losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans.  Our policy dictates that we maintain an allowance for loan losses.  The amount of the allowance is based on managements evaluation of our loan portfolio, the financial condition of the borrowers, current economic conditions, past and expected loan loss experience, and other factors management deems appropriate.  Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations.



We Compete with Larger Companies for Business



Commercial banking in North Carolina is extremely competitive due in large part to statewide branching.  The bank competes in the North Carolina market area with some of the largest banking organizations in the state and the country and other financial institutions, such as federally and state-chartered savings and loan institutions and credit unions, as well as consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit.  Many of these competitors have broader geographic markets, higher lending limits, more services, and more media advertising.  We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition.



We Are Exposed to Certain Market Risks



Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market price and interest rates.  Our market risk stems primarily from interest rate risk inherent in our lending and deposit-taking activities.  Our policy allows that we may maintain derivative financial instruments, such as interest rate swap agreements, to manage such risk.



To manage the risk of potentially decreasing interest rates for our variable rate loan portfolio, we use an interest rate swap agreement whereby we contract to receive fixed rate payments and in turn, we agree to make variable interest payments for a defined time period.  In addition, we used fixed rate time deposits, such as certificates of deposits, for use in our lending and investment activities.  If the interest rates decline, we face the risk of being committed to pay a fixed rated that is higher than the fair value rate of such deposits.  To manage this risk, we use interest rate swaps whereby we contract to make a series of floating rate payments in exchange for receiving a series of fixed rate payments.



Because the value of derivative contracts is tied to an independent instrument, index or reference rate, the contracts are written in abstract amounts that only provide the basis for calculating payments between counterparties, i.e., notional amounts.  Credit risk arises when amounts receivable from the counterparty exceed amounts payable, or when the counterparty fails to pay.  The counterparties to these contracts are primarily large commercial banks and investment banks.  We control our risk of loss on derivative contracts by subjecting each contracting counterparty to credit reviews and approvals similar to those used in making loans and other extensions of credit, and we continuously monitor these agreements.  Other risks include the effect on fixed rate positions during periods of changing interest rates, e.g., when interest rates fall, the notional amounts decrease more rapidly, whereas when interest rates rise, the notional amounts decrease more slowly.





11



---





Technological Advances



The banking industry undergoes technological changes with frequent introductions of new technology-driven products and services.  In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs.  Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations.  Many of our competitors, however, have substantially greater resources to invest in technological improvements.



Compliance with Changing Laws, Regulations and Standards May Result in Additional Risks and Expenses



We are subject to changing laws, regulations and standards, including the BHCA, the GLB, the IBBEA, the USA Patriot Act of 2001, the FDIC, the CRA, the North Carolina Business Corporation Act, the Sarbanes-Oxley Act of 2002 and new SEC regulations to name a few.



The Sarbanes-Oxley Act and new SEC regulations, in particular, are creating uncertainty for companies such as ours because they are subject to varying interpretations in many cases.  As a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices.  We are committed to maintaining high standards of corporate governance and public disclosure.  As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention.  Specifically, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding managements required assessment of our internal control over financial reporting and our external auditors audit of that assessment has required the commitment of significant financial and managerial resources.  We expect these efforts to require the continued commitment of significant resources.  Further, the members of our Board of Directors, members of the Audit or Compensation committees, our Chief Executive Officer, our Chief Financial Officer and certain other of our executive officers could face an increased risk of personal liability in connection with the performance of their duties.  In addition, it may become more difficult and more expensive to obtain director and officer liability insurance.  As a result, our ability to attract and retain executive officers and qualified Board and committee members could be more difficult.



Government Regulations May Prevent or Impair Our Ability to Pay Dividends, Engage in Acquisitions or Operate in Other Ways



Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations.  We are subject to supervision and a periodic examination by the Federal Reserve Bank and the North Carolina State Banking Commission.  Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as:



·

The payment of dividends to our shareholders;

·

Possible mergers with or acquisitions of or by other institutions.

·

Our desired investments;

·

Loans and interest rates on loans;

·

Interest rates paid on deposits;

·

The possible expansion of branch offices; and/or

·

Our ability to provide securities or trust services.



We also are subject to capitalization guidelines set forth in federal legislation, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized.  We cannot predict what changes, if any, will be made to existing federal and state legislation and regulators or the effect that such changes may have on our future business and earnings prospects.  The cost of compliance with regulatory requirements including those imposed by the SEC may adversely affect our ability to operate profitably.





12



---





We Depend Heavily on our Key Management Personnel



Our success depends in part on our ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small to mid-size bank.  Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require.  We expect to effectively compete in this area by offering competitive financial packages that include incentive-based compensation.



We Have a High Concentration of Loans Secured by Real Estate



A significant portion of our loan portfolio is dependent on real estate.  In addition to the financial strength and cash flow characteristics of the borrower in each case, often loans are secured with real estate collateral.  At December 31, 2006, approximately 87.4% of our loans have real estate as a primary or secondary component of collateral.  The real estate in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended.  An adverse change in the economy affecting values of real estate generally or in our primary markets specifically could significantly impair the value of collateral and ability to sell the collateral upon foreclosure.  Furthermore, it is likely that, in a decreasing real estate market, we would be required to increase our allowance for loan losses.  If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values or to increase our allowance for loan losses, our profitability and financial condition could be adversely impacted.



Our Allowance for Probable Loan Losses May Be Insufficient



We maintain an allowance for probable loan losses, which is a reserve established through a provision for probable loan losses charged to expense.  This allowance represents managements best estimate of probable losses that have been incurred within the existing portfolio of loans.  The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio.  The level of the allowance reflects managements continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio.  The determination of the appropriate level of the allowance for probable loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates and assumptions regarding current credit risks and future trends, all of which may undergo material changes.  Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside our control, may require an increase in the allowance for probable loan losses.  In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for probable loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  In addition, if charge-offs in future periods exceed the allowance for probable loan losses, we will need additional provisions to increase the allowance for probable loan losses.  Any increases in the allowance for probable loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations.  See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations for further discussion related to our process for determining the appropriate level of the allowance for probable loan losses.



We Are Subject To Environmental Liability Risk Associated With Lending Activities



A significant portion of our loan portfolio is secured by real property.  During the ordinary course of business, we may foreclose on and take title to properties securing certain loans.  In doing so, there is a risk that hazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage.  Environmental laws may require us to incur substantial expenses and may materially reduce the affected propertys value or limit our ability to use or sell the affected property.  In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.  Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards.  The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.





13



---





Our Controls and Procedures May Fail or Be Circumvented



Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures.  Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met.  Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.



The Holders of Our Subordinated Debentures Have Rights That Are Senior to Those of Our Shareholders



As described below, we have issued $12.0 million of subordinated debentures in connection with three trust preferred securities issuances by our subsidiary, the Trust.  We conditionally guarantee payments of the principal and interest on the trust preferred securities.  Our subordinated debentures are senior to our shares of common stock.  As a result, we must make payments on the subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock.



Our Information Systems May Experience an Interruption or Breach in Security



We rely heavily on communications and information systems to conduct our business.  Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems.  While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.



An Investment in Our Common Stock Is Not an Insured Deposit



Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity.  Investment in our common stock is inherently risky for the reasons described in this Risk Factors section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company.  As a result, if you acquire our common stock, you may lose some or all of your investment.



Consumers May Decide Not To Use Banks to Complete Their Financial Transactions



Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods.  For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds.  Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks.  The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits.  The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.





Item 1B  Unresolved Staff Comments.



Not applicable.





14



---





Item 2 - Properties.



The bank owns its main office, which is located at 6144 US 301 South, Four Oaks, North Carolina.  The main office, which was constructed by the bank in 1985, is a 12,000 square foot facility on 1.64 acres of land.  The bank leases a limited-service facility in downtown Four Oaks located at 111 North Main Street from M.S. Canaday, who is a former director of the Company as well as a former director of the bank.  Under the terms of the lease, which the bank believes to be arms-length, the bank paid $970 per month in rent in 2006.  The lease is month-to-month and we review its terms on an annual basis.  The bank also leases a branch office located at 101 West Center Street, Holly Springs, North Carolina.  Under the terms of the lease, the bank will pay $2,508 per month for a period of five years ending April 1, 2008.   The banks Harrells office located at 590 Tomahawk Highway, Harrells, North Carolina is under a lease with terms specifying the bank will pay $600 each month for the period beginning January 1, 2006 and ending December 31, 2009.  In addition, the bank has entered into a ten-year lease on its Sanford office located at 830 Spring Lane Sanford, North Carolina.  Under the terms of the lease, the bank will pay $7,170 each month with an annual rate increase not to exceed 2.5% over a 5 year period.  Late in December 2005, the bank signed a yearly lease with an annual option to renew for its new Zebulon office located at 130 North Arendell Avenue, Zebulon, North Carolina for $1,000 per month beginning January 1, 2006, the lease has now been converted to a month to month tenancy pending the completion of the permanent branch location in 2007.  The bank owns a 5,000 square foot facility renovated in 1992 on 1.15 acres of land located at 5987 US 301 South, Four Oaks, North Carolina which houses its training center.  The bank also owns a 15,000 square foot facility built in 2000 located at 6114 US 301 South, Four Oaks, North Carolina, which houses its administrative offices, data operations, loan operations and wide area network central link.  In addition, the bank owns the following:



|                                 |  |            |  |                          |  |            
|-------------------------------- |  | ---------- |  | ------------------------ |  | -----------
|Location                         |  | Year Built |  | Present Function         |  | Square Feet
|                                 |  |            |  |                          |  |            
|102 East Main Street             |  |            |  |                          |  |            
|Clayton, North Carolina          |  | 1986       |  | Branch Office            |  | 4,900      
|                                 |  |            |  |                          |  |            
|200 East Church Street           |  |            |  |                          |  |            
|Benson, North Carolina           |  | 1987       |  | Branch Office            |  | 2,300      
|                                 |  |            |  |                          |  |            
|128 North Second Street          |  |            |  |                          |  |            
|Smithfield, North Carolina       |  | 1991       |  | Branch Office            |  | 5,500      
|                                 |  |            |  |                          |  |            
|403 South Brightleaf Boulevard   |  |            |  |                          |  |            
|Smithfield, North Carolina       |  | 1995       |  | Limited-Service Facility |  | 860        
|                                 |  |            |  |                          |  |            
|200 Glen Road                    |  |            |  |                          |  |            
|Garner, North Carolina           |  | 1996       |  | Branch Office            |  | 3,500      
|                                 |  |            |  |                          |  |            
|325 North Judd Parkway Northeast |  |            |  |                          |  |            
|Fuquay-Varina, North Carolina    |  | 2002       |  | Branch Office            |  | 8,900      
|                                 |  |            |  |                          |  |            
|406 East Main Street             |  |            |  |                          |  |            
|Wallace, North Carolina          |  | 2006       |  | Branch Office            |  | 9,300      



Management believes each of the properties referenced above is adequately covered by insurance.  In addition to the above locations, we have one ATM located inside Blackmons Country store in Four Oaks and 15 ATMs in Food Lion grocery stores in the cities and towns of Clayton, Benson, Sanford, Wallace, Fuquay-Varina, Holly Springs, Garner, Zebulon and Wendell, North Carolina.  The net book value for our properties, including land, buildings, and furniture and equipment was $11.6 million at December 31, 2006.  Additional information disclosed in Note D Bank Premises and Equipment to our consolidated financial statements presented under Item 8 of Part II of this Form 10-K.





15



---





Item 3 - Legal Proceedings.



We are not involved in any material legal proceedings at the present time.

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



None.



16



---









PART II

Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.



Our common stock trades on the OTC Bulletin Board under the symbol FOFN.  The range of high and low bid prices of our common stock for each quarter during the two most recent fiscal years, as published by the OTC Bulletin Board, adjusted for stock splits, is as follows (prices reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions):



|               |                                |       |      |   |       |  |     |       |  |   |      
|-------------- | ------------------------------ | ----- | ---- | - | ----- |  | --- | ----- |  | - | -----
|               | Fiscal Year Ended December 31,
|               | 2005                           |       | 2006
|               | High                           |       | Low  |   | High  |  | Low
|First quarter  | $                              | 15.36 |      | $ | 14.08 |  | $   | 19.80 |  | $ | 17.40
|Second quarter |                                | 18.56 |      |   | 14.91 |  |     | 27.20 |  |   | 19.40
|Third quarter  |                                | 19.20 |      |   | 15.84 |  |     | 24.00 |  |   | 19.80
|Fourth quarter |                                | 20.00 |      |   | 15.84 |  |     | 28.00 |  |   | 23.60



As of March 15, 2007, the approximate number of holders of record of our common stock was 1,500. We have no other class of equity securities. The banks ability to declare a dividend to us and the companys ability to pay dividends are subject to the restrictions of the North Carolina Business Corporation Act.  There also are state banking laws that require a surplus of at least 50% of paid-in capital stock be maintained in order for the bank to declare a dividend to the company.  Subject to the legal availability of funds to pay dividends, cash dividends paid by us in 2006 and 2005, after giving effect to the 5-for-4 stock splits during 2006 and 2005, were $0.26 and $0.24 per share, respectively.



We did not sell any securities in 2006 that were not registered under the Securities Act of 1933 as amended.  During 2006, we repurchased 10,500 shares of our equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended.



The following information in this item 5 of this annual report on Form 10-K is not deemed to be soliciting material or to be filed with the SEC or subject to Regulation 14A or 14C under the Securities Exchange Act of 1934 or to the liabilities of Section 18 of the Securities Exchange Act of 1934, and will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate it by reference into such a filing.



Comparison of Cumulative Total Return



The following graph compares the cumulative total shareholder return on our common stock over the five-year period ended December 31, 2006, with the cumulative total return for the same period on the Nasdaq Composite Index, the SNL South OTC-BB and Pink Banks Index and the SNL $100-$500M OTC-BB & Pink Banks Index.  The graph assumes that at the beginning of the period indicated $100 was invested in our common stock and the stock of the companies comprising the Nasdaq Composite Index, the SNL South OTC-BB and Pink Banks Index and the SNL $100-$500M OTC-BB & Pink Banks Index,and that all dividends, if any, were reinvested.



17



---







[f2006fouroaks10k002.gif]





|                                    |                            |        |      |   |        |  |      |        |      |   |        |  |   |        |  |   |       
|----------------------------------- | -------------------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ |  | - | ------
|                                    | Period Ending December 31,
|Index                               | 2001                       |        | 2002 |   | 2003   |  | 2004 |        | 2005 |   | 2006  
|Four Oaks Fincorp, Inc.             | $                          | 100.00 |      | $ | 117.25 |  | $    | 133.44 |      | $ | 177.72 |  | $ | 231.53 |  | $ | 346.32
|NASDAQ Composite                    |                            | 100.00 |      |   | 68.76  |  |      | 103.67 |      |   | 113.16 |  |   | 115.57 |  |   | 127.58
|SNL South OTC-BB and Pink Banks     |                            | 100.00 |      |   | 124.58 |  |      | 166.79 |      |   | 194.62 |  |   | 222.91 |  |   | 259.92
|SNL $100M-$500M OTC-BB & Pink Banks |                            | 100.00 |      |   | 119.95 |  |      | 162.94 |      |   | 196.93 |  |   | 218.70 |  |   | 239.40





Item 6 - Selected Financial Data



The following table sets forth certain historical consolidated financial data for the periods indicated.  The selected historical annual consolidated statement of operations and balance sheet data as of each of the fiscal years ended December 31, 2006 and 2005 and are derived from, and are qualified in their entirety by, our audited consolidated financial statements included elsewhere in this report.  The selected historical annual consolidated statement of operations data for each of the years ended December 31, 2003 and 2002 and balance sheet date as of each of the years ended December 31, 2004, 2003 and 2002 are derived from audited consolidated financial statements not included herein.  Historical results are not necessarily indicative of the results to be expected in the future.  You should read the following data together with Item 1. Business, Item 7.  Managements Discussion and Analysis of Financial Condition and Results of Operations, and our audited consolidated financial statements and the related notes appearing in Item 8. Financial Statements.  (dollars in thousands, except per share data).



18



---









|                         |                                     |                                           |           |      |   |           |  |      |           |      |   |           |  |   |          
|------------------------ | ----------------------------------- | ----------------------------------------- | --------- | ---- | - | --------- |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|                         |                                     | As of and for the Year Ended December 31,
|                         |                                     | 2006                                      |           | 2005 |   | 2004      |  | 2003 |           | 2002
|Operating Data:          |                                     |                                           |           |      |   |           |  |      |           |      |   |           |  |  
|                         | Total interest income               | $                                         | 40,556    |      | $ | 29,404    |  | $    | 21,748    |      | $ | 18,943    |  | $ | 19,785   
|                         | Total interest expense              |                                           | 17,817    |      |   | 9,983     |  |      | 5,811     |      |   | 5,922     |  |   | 7,640    
|                         | Net interest income                 |                                           | 22,739    |      |   | 19,421    |  |      | 15,937    |      |   | 13,021    |  |   | 12,145   
|                         | Provision for loan losses           |                                           | 873       |      |   | 1,403     |  |      | 1,596     |      |   | 1,373     |  |   | 1,248    
|                         | Net interest income after provision |                                           | 21,866    |      |   | 18,018    |  |      | 14,341    |      |   | 11,648    |  |   | 10,897   
|                         | Noninterest income                  |                                           | 4,275     |      |   | 3,077     |  |      | 3,849     |      |   | 3,470     |  |   | 2,810    
|                         | Noninterest expense                 |                                           | 15,497    |      |   | 13,354    |  |      | 11,507    |      |   | 10,588    |  |   | 9,485    
|                         | Income before income taxes          |                                           | 10,644    |      |   | 7,741     |  |      | 6,683     |      |   | 4,530     |  |   | 4,222    
|                         | Provision for income taxes          |                                           | 3,627     |      |   | 2,738     |  |      | 2,308     |      |   | 1,612     |  |   | 1,306    
|                         | Net income                          | $                                         | 7,017     |      | $ | 5,003     |  | $    | 4,375     |      | $ | 2,918     |  | $ | 2,916    
|                         |                                     |                                           |           |      |   |           |  |      |           |      |   |           |  |   |          
|Per Share Data: (Note A) |                                     |                                           |           |      |   |           |  |      |           |      |   |           |  |  
|                         | Earnings per share - basic          | $                                         | 1.27      |      | $ | 0.92      |  | $    | 0.82      |      | $ | 0.56      |  | $ | 0.56     
|                         | Earnings per share - diluted        |                                           | 1.26      |      |   | 0.91      |  |      | 0.82      |      |   | 0.55      |  |   | 0.56     
|                         | Cash dividends declared             |                                           | 0.26      |      |   | 0.24      |  |      | 0.20      |      |   | 0.18      |  |   | 0.16     
|                         | Market price                        |                                           |           |      |   |           |  |      |           |      |   |           |  |   |          
|                         | High                                |                                           | 28.00     |      |   | 25.00     |  |      | 20.00     |      |   | 16.64     |  |   | 12.03    
|                         | Low                                 |                                           | 17.40     |      |   | 17.60     |  |      | 13.44     |      |   | 11.26     |  |   | 10.50    
|                         | Close                               |                                           | 26.75     |      |   | 22.61     |  |      | 17.60     |      |   | 13.44     |  |   | 12.03    
|                         | Book value                          |                                           | 8.84      |      |   | 7.60      |  |      | 6.94      |      |   | 6.29      |  |   | 5.95     
|                         |                                     |                                           |           |      |   |           |  |      |           |      |   |           |  |   |          
|                         | Weighted average shares outstanding |                                           |           |      |   |           |  |      |           |      |   |           |  |   |          
|                         | Basic                               |                                           | 5,527,980 |      |   | 5,429,157 |  |      | 5,308,351 |      |   | 5,243,859 |  |   | 5,196,813
|                         | Diluted                             |                                           | 5,579,293 |      |   | 5,469,381 |  |      | 5,338,562 |      |   | 5,262,564 |  |   | 5,213,853





19



---









|                                      |                                                            |                                           |         |   |         |   |         |   |         |   |        
|------------------------------------- | ---------------------------------------------------------- | ----------------------------------------- | ------- | - | ------- | - | ------- | - | ------- | - | -------
|                                      |                                                            | As of and for the Year Ended December 31,
|                                      |                                                            |                                           | 2006    |   | 2005    |   | 2004    |   | 2003    |   | 2002   
|Selected Year-End Balance Sheet Data: |                                                            |                                           |         |   |         |   |         |   |         |  
|                                      | Total assets                                               | $                                         | 608,137 | $ | 522,872 | $ | 398,500 | $ | 341,721 | $ | 318,289
|                                      | Loans                                                      |                                           | 461,763 |   | 397,094 |   | 312,815 |   | 272,623 |   | 229,570
|                                      | Allowance for loan losses                                  |                                           | 5,566   |   | 4,965   |   | 4,055   |   | 3,430   |   | 2,860  
|                                      | Deposits                                                   |                                           | 466,868 |   | 398,341 |   | 315,307 |   | 272,918 |   | 250,573
|                                      | Short-term borrowings                                      |                                           | 73,400  |   | 74,140  |   | 43,160  |   | 33,160  |   | 33,160 
|                                      | Subordinated Debentures                                    |                                           | 12,372  |   | -       |   | -       |   | -       |   | -      
|                                      | Shareholders' equity                                       |                                           | 49,323  |   | 41,612  |   | 37,295  |   | 32,880  |   | 31,193 
|                                      |                                                            |                                           |         |   |         |   |         |   |         |   |        
|Selected Average Balances:            |                                                            |                                           |         |   |         |   |         |   |         |  
|                                      | Total assets                                               | $                                         | 560,689 | $ | 449,462 | $ | 376,422 | $ | 324,222 | $ | 308,334
|                                      | Loans                                                      |                                           | 426,768 |   | 351,103 |   | 298,783 |   | 249,240 |   | 216,620
|                                      | Total interest-earning assets                              |                                           | 528,056 |   | 419,307 |   | 349,596 |   | 300,672 |   | 290,294
|                                      | Deposits                                                   |                                           | 435,991 |   | 355,214 |   | 295,524 |   | 255,038 |   | 242,878
|                                      | Total interest-bearing liabilities                         |                                           | 435,131 |   | 340,798 |   | 282,743 |   | 244,024 |   | 236,661
|                                      | Shareholders' Equity                                       |                                           | 45,541  |   | 39,613  |   | 35,135  |   | 32,341  |   | 29,931 
|                                      |                                                            |                                           |         |   |         |   |         |   |         |   |        
|Selected Performance Ratios:          |                                                            |                                           |         |   |         |   |         |   |         |  
|                                      | Return on average assets                                   |                                           | 1.25%   |   | 1.11%   |   | 1.16%   |   | 0.90%   |   | 0.95%  
|                                      | Return on average equity                                   |                                           | 15.41%  |   | 12.63%  |   | 12.45%  |   | 9.02%   |   | 9.74%  
|                                      | Net interest spread                                        |                                           | 4.17%   |   | 4.08%   |   | 4.16%   |   | 3.87%   |   | 3.59%  
|                                      | Net interest margin (yield)                                |                                           | 4.31%   |   | 4.63%   |   | 4.56%   |   | 4.33%   |   | 4.18%  
|                                      | Noninterest income to total revenue                        |                                           | 15.83%  |   | 13.68%  |   | 19.45%  |   | 21.04%  |   | 18.79% 
|                                      | Noninterest income to average assets                       |                                           | 0.76%   |   | 0.68%   |   | 1.02%   |   | 1.07%   |   | 0.91%  
|                                      | Noninterest expense to average assets                      |                                           | 2.76%   |   | 2.97%   |   | 3.06%   |   | 3.27%   |   | 3.08%  
|                                      | Efficiency ratio                                           |                                           | 57.33%  |   | 58.51%  |   | 58.58%  |   | 66.15%  |   | 64.14% 
|                                      | Dividend payout ratio                                      |                                           | 20.47%  |   | 26.09%  |   | 24.39%  |   | 32.14%  |   | 28.57% 
|                                      |                                                            |                                           |         |   |         |   |         |   |         |   |        
|Asset Quality Ratios:                 |                                                            |                                           |         |   |         |   |         |   |         |  
|                                      | Nonperforming loans to period-end loans                    |                                           | 0.18%   |   | 0.25%   |   | 0.30%   |   | 0.39%   |   | 0.67%  
|                                      | Allowance for loan losses to period-end loans              |                                           | 1.21%   |   | 1.25%   |   | 1.30%   |   | 1.26%   |   | 1.25%  
|                                      | Allowance for loan losses to nonperforming loans           |                                           | 663.41% |   | 497.99% |   | 429.56% |   | 323.89% |   | 186.08%
|                                      | Nonperforming assets to total assets                       |                                           | 0.20%   |   | 0.25%   |   | 0.39%   |   | 0.52%   |   | 0.65%  
|                                      | Net loan charge-offs to average loans                      |                                           | 0.06%   |   | 0.14%   |   | 0.32%   |   | 0.32%   |   | 0.48%  
|                                      |                                                            |                                           |         |   |         |   |         |   |         |   |        
|Capital Ratios:                       |                                                            |                                           |         |   |         |   |         |   |         |  
|                                      | Total risk-based capital - Bank                            |                                           | 11.63%  |   | 10.40%  |   | 11.80%  |   | 12.30%  |   | 14.00% 
|                                      | Tier 1 risk-based capital - Bank                           |                                           | 12.79%  |   | 9.19%   |   | 10.60%  |   | 11.10%  |   | 12.80% 
|                                      | Leverage ratio - Bank                                      |                                           | 9.31%   |   | 7.66%   |   | 8.60%   |   | 9.00%   |   | 9.70%  
|                                      | Equity to assets ratio                                     |                                           | 8.11%   |   | 7.96%   |   | 9.36%   |   | 9.62%   |   | 9.80%  
|                                      | Equity to assets ratio (averages)                          |                                           | 8.12%   |   | 8.81%   |   | 9.33%   |   | 9.97%   |   | 9.71%  
|                                      | Average interest earning assets to average tot assets      |                                           | 94.18%  |   | 93.29%  |   | 92.87%  |   | 92.74%  |   | 94.15% 
|                                      | Average  loans to average total deposits                   |                                           | 97.88%  |   | 98.84%  |   | 101.10% |   | 97.73%  |   | 89.19% 
|                                      | Average interest bearing liabilities to avg int earn asset |                                           | 82.40%  |   | 81.28%  |   | 80.88%  |   | 81.16%  |   | 81.52% 
|                                      |                                                            |                                           |         |   |         |   |         |   |         |   |        
|Other Data:                           |                                                            |                                           |         |   |         |   |         |   |         |  
|                                      | Number of banking offices                                  |                                           | 13      |   | 12      |   | 10      |   | 10      |   | 9      
|                                      | Number of full time equivalent employees                   |                                           | 156     |   | 135     |   | 131     |   | 126     |   | 122    





20



---









Item 7  Managements Discussion and Analysis of Financial Condition and Results of Operations.



The following discussion and analysis provides information about the major components of our results of operations and financial condition, liquidity and capital resources and should be read in conjunction with our audited consolidated financial statements and notes thereto which are contained in this report.  Additional discussion and analysis related to fiscal year 2006 is contained in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, 2006, June 30, 2006 and September 30, 2006, respectively.



Overview



As a community-focused commercial bank, our primary business consists of providing a full range of banking services to our customers with an emphasis on quality personal service. Our core products consist of loans secured by real estate and commercial and consumer loans as well as various deposit products to meet our customers needs.  Our primary source of income is generated from net interest income, the difference between interest income received on our loans and securities and interest expense paid on deposits and borrowings.   Our income is also affected by our ability to price our products competitively and maximize the interest rate spread between the interest yield on loans and securities and the interest rate paid on deposits and borrowings.  Our products also generate other income through product related fees and commissions.  We incur operating expenses consisting primarily of salaries and benefits, occupancy and equipment and other professional and miscellaneous expenses.



Our assets have increased from $318.3 million at December 31, 2002 to $608.1 million at December 31, 2006, primarily due to increased loan demand, while our total deposits have increased from $250.6 million to $466.9 million over that same period.  In addition, for 70 consecutive years, we have paid dividends (prior to 1997 when we reorganized into a holding company, it was our wholly owned subsidiary, Four Oaks Bank & Trust Company, which paid dividends). For the past five years, dividends have averaged 25.6% of our average net income. Return on average equity and return on average assets for 2006 were 15.41% and 1.25%, respectively, up over returns of 12.63% and 1.11%, respectively, for 2005.



We set interest rates on deposits and loans at competitive rates while maintaining spreads of 4.17% and 4.08% in 2006 and 2005, respectively, between interest earned on average loans and investments and interest paid on average interest-bearing deposits and borrowings.  Our gross loans have increased from $229.6 million at December 31, 2002 to $461.8 million at December 31, 2006, while our average net annual charge-offs over the same period were approximately $715,000.  The sustained growth provided by operations resulted in increases in total assets of 16.3%, 31.2%, and 16.6% for 2006, 2005 and 2004, respectively.



Our gross loans grew 16.3% and 26.9%  in 2006 and 2005, respectively.  Our total investments (including interest-earning deposits and FHLB stock) increased 16.9% and 59.7% in 2006 and 2005, respectively, due to the decision to build the portfolio as yields have continued to improve throughout 2005 and 2006. We closely monitor changes in the financial markets in order to maximize the yield on our assets.  The growth in loans for 2006 and 2005 was funded by deposit growth of 17.2% and 26.3%, respectively, and net income of $7.0million and $5.0 million, respectively, for 2006 and 2005.  Improved earnings trends continued during 2006, ending the year with net income of $7.0 million, an increase of 40.3% over 2005s net income of $5.0 million.  This increase was primarily due to an increase in both net interest income and non-interest income.   Strategic pricing of both loans and deposits and improved yields in our investment portfolio kept the margin from decreasing significantly due to the overall increase in interest expense.



During 2006 and 2005, Four Oaks Mortgage Company, L.P. provided secondary market-type mortgages which contributed $135,000 and $106,000 in income for the years 2006 and 2005, respectively.  Four Oaks Mortgage Company, L.P. is owned 49.99% by our wholly owned subsidiary, Four Oaks Mortgage Services, L.L.C., and 50.01% by its general partner, CTX Mortgage Ventures, LLC, a wholly owned indirect subsidiary of Centex Corporation.



In December 2004, we added the Retail Real Estate Lending division, which works with individuals, developers and contractors involved in real estate acquisition and development.





21



---





Management historically has monitored and controlled increases in overhead expenses while being committed to developing the skills and enhancing the professionalism of our employees.  Employee turnover has been minimal, while the number of full-time equivalent employees has increased from 122 at December 31, 2002 to 156 at December 31, 2006.



Results of Operations



Comparison of Financial Condition at December 31, 2006 and 2005



During 2006, our total assets increased by $85.3 million, or 16.3%, from $522.9 million at December 31, 2005 to $608.1 million at December 31, 2006.  This increase in our total assets resulted primarily from growth in our net loans, which increased from $392.1 million at December 31, 2005 to $456.2 million at December 31, 2006, an increase of $64.1 million, or 16.3%.  The sustained growth in our loan portfolio continues to reflect a trend towards growth in commercial real estate lending primarily in real estate construction as a result of a continued shift in our markets from an agricultural focus to a suburban focus.  Loans secured by real estate at December 31, 2006 of which $51.9 million was related to construction and land development loans, grew $71.7 million over the prior year.   In addition to loan growth, our securities portfolio increased $21.2 million to $101.4 million at December 31, 2006. Our loan growth and increases in our securities portfolio were primarily funded by deposit growth of $68.5 million, or 17.2%, during 2006 to $466.9 million at December 31, 2006 compared with $398.4 million at December 31, 2005.  Our local market customers continue to be our primary source for deposit growth, funding deposit growth predominantly in savings and time deposits.  Deposits from our local market customers provided $72.1 million of the December 31, 2006 increase in deposits over December 31, 2005, offset by a $3.6 million decrease in deposits outside our local customer base.  The growth in deposits was encouraged by increased deposit rates as the national prime increased from 7.25% at January 1, 2006 to 8.25% at December 31, 2006 and successful deposit campaigns and branch calling efforts within our competitive market.



Shareholders equity increased by $7.7 million during 2006. This increase resulted from our net income of $7.0 million, dividend reinvestment plan proceeds of $792,000,proceeds from the exercise of stock options of $586,000 and employee stock purchase plan proceeds of $137,000, net of dividends paid of $1.4 million and other comprehensive gain of $348,000 comprised of unrealized gains on securities available for sale of $161,000, net of tax and unrealized gains on cash flow hedging activities of $187,000 net of tax.



Comparison of Operating Results for the Years Ended December 31, 2006 and 2005



Net Income



During 2006, we earned net income of $7.0 million, or $1.27 basic net income per share, which was a 40.3% increase over 2005 net income of $5.0 million, or $0.92 basic net income per share. We believe strategic pricing of both our loans and deposits improved our net interest margin by managing our overall cost of funds and allowing us to attract the higher balance, higher quality loans in our markets.  The resulting $3.3 million, or 17.1%, increase in net interest income absorbed a 16.1% increase in non-interest expense for 2006 over the prior year.  A full year of opening and operating two new full-service offices during 2006 contributed to increased salaries and benefits, occupancy and equipment and other operating costs, along with costs associated with the completion of the new building for Wallace and the upfitting of the new Sanford location.  In addition to the new offices, rising costs in employee benefits contributed to increased personnel expense.  Compliance costs related to the Sarbanes-Oxley Act of 2002 increased costs for outside professional services.



Net Interest Income



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





22



---





Net interest income increased to $22.7 million in 2006, with a net yield of 4.31%, compared to $19.4 million and a net yield of 4.63% in 2005, which was an increase of $3.3 million, but the yield decreased an overall 32 basis points from 2005 due to the increasing costs of deposits and borrowings.  The increase in net interest income primarily was generated by an increased volume of $14.4 million in average net interest-earning assets, which produced $3.3 million in net interest income.  The additional interest income over interest expense was driven by strong loan demand in a rising rate environment, acquisition of higher yielding investments as well as an increase of $7.6 million in average non-interest-bearing demand deposits.  The rates earned on a substantial portion of our loans reprice to correspond with each prime rate increase.  Most of our interest-bearing liabilities, however, have fixed interest rates until maturity and as a result do not reprice as quickly or in the same increments as our loan portfolio.  The national prime increased 100 basis points during 2006 to 8.25% at December 31, 2006 from 7.25% at January 1, 2006.  Since the last prime rate increase was June 29, 2006, our loan repricing leveled off in the latter part of 2006, while our deposits continued to reprice upwards as they reached maturity, which accounts for the decrease in net interest margin for 2006.



On average, interest-earning assets grew $108.7 million during 2006 over the prior year period.  A substantial portion of the increase in interest-earning assets was achieved through increased loan demand.  Average loans increased $75.7 million during 2006 over the prior year to $426.8 million, generating additional interest income of $3.6 million. Rising interest rates generated additional interest income of $2.8 million on the banks loan portfolio. An increase in volume of interest-bearing liabilities of $94.3 million resulted in additional interest expense of $3.6 million while repricing due to rising interest rates increased interest expense by $4.2 million.  The increase in interest expense primarily resulted from a $33.2 million increase in higher costing jumbo time deposits at an average rate paid on these deposits of 4.42% an increase of 113 basis points over the prior year.  However, an increase of $24.5 million in lower costing NOW and money market deposits at an average rate paid of 2.89% and an increase of $7.6 million in interest free demand deposits partially offset the increased cost of the jumbo time deposits.

Interest expense on subordinated debt associated with our offering of the Trust Preferred Securities increased from zero in 2005 to $626,000 in 2006. The average outstanding balance of subordinated debt increased from zero in 2005 to $9.4 million in 2006, as we completed a $12 million offering of Trust Preferred Securities in late March 2006. The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%.



Provision for Loan Losses and Asset Quality



Our provision for loan losses was $873,000 during 2006 and $1.4 million during 2005.  Net charge-offs in 2006 declined to $272,000 compared to $493,000 in 2005. As a percent of average loans, net charge-offs were 0.06%, the lowest level in the past five years.  The lower level of net-charge-offs and nonperforming assets is attributable to continued efforts to improve asset quality, including improved underwriting.



The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from managements consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve.  Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio.  In addition, various regulatory agencies periodically review our allowance for loan losses.  These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination.  See Allowance for Loan Losses and Summary of Loan Loss Experience below.  We evaluate our loan portfolio in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loans observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses.   This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change.





23



---





Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, remained unchanged at $1.3 million at December 31, 2005 and December 31, 2006.  Our allowance for loan losses, expressed as a percentage of gross loans, was 1.21% and 1.25% at December 31, 2006 and 2005, respectively.  At December 31, 2006, the allowance for loan losses amounted to $5.6 million, which management believes is adequate to absorb losses inherent in our loan portfolio.



Non-interest Income



Non-interest income before gains and losses on sales of securities, hedging activity and loans increased $756,000, or 19.9%, from $3.8 million during 2005 to $4.6 million in 2006. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, bank-owned life insurance income and various other sources of miscellaneous operating income.  Fees charged on deposit accounts, our largest component of non-interest income, increased $178,000 for 2006 compared to 2005, primarily due to an increase in overdraft charges.  Merchant fees increased $13,000 from $389,000 during 2005 to $402,000 in 2006, primarily due to increased customer use of debit cards. During the same period, other service charges, commissions and fees increased $316,000, of which $29,000 was attributable to increased profits from our investment in Four Oaks Mortgage Company, L.P., $117,000 was attributable to increased commissions from our financial services department $235,000 was attributable to the return on investment in the Triangle Mezzanine Fund and $19,000 from the equity earnings in The Four Oaks Statutory Trust.  Income from bank-owned life insurance increased $249,000. Net gains of $400,000 on sales of investment securities and interest rate hedging activity were recognized in 2006.  Our net gains on sales of loans increased to $103,000 in 2006 from $61,000 recorded in 2005.  The increase in loan sales was driven by strong loan demand in a rising rate environment.



Non-interest Expense



Our non-interest expense increased from $13.4 million in 2005 to $15.5 million in 2006, an increase of $2.1 million. Although our non-interest expense has continued to increase, our non-interest expense as a percent of our average assets has declined over the last five years, down to 2.76% for 2006, our lowest level in the last five years.  Approximately 60.7% of the $2.1 million increase in non-interest expense over 2005 was due to increases in salaries and benefits. Salaries increased 18.7% while employee benefits increased 13.0%, primarily due a 15.6% increase in the number of employees in 2006 over 2005.  In addition to normal salary increases and increased costs for employee benefits overall, personnel costs grew due to additional staffing needs throughout the bank.  In total, our number of full time equivalent employees grew from 135 employees for the year 2005 to 156 employees for the year 2006. The increased personnel costs reflect the costs of a full year of staffing for our new Zebulon office which opened in January 2006, and the increased staffing in Sanford when we converted that office from a loan production office to a full-service branch.  In addition to personnel costs, additional costs during 2006 were incurred in occupancy and equipment due to the additional staff, operating new offices, as well as general upgrades in technology throughout the bank. For 2006, occupancy and equipment expense increased $132,000 and $125,000, respectively, over the prior year. Additional testing and documentation required for compliance with the Sarbanes-Oxley Act of 2002 continued to increase our fees paid for outside professional services in 2006, contributing to an increase of $218,000 in professional and consulting fees over 2005. The primary increases in other non-interest expense for 2006 over the prior year period included advertising expense, up $111,000, printing and office supplies, up $42,000, telephone expense, up $15,000, auto expense, up $18,000, directors fees, up $26,000, meals, entertainment and travel, up $24,000, donations and charities expense up, $21,000, ATM expense, up $20,000, and servicing expense, up $16,000. There were no other significant increases in the remaining other non-interest expense categories.



Comparison of Operating Results for the Years Ended December 31, 2005 and 2004



Net Income



During 2005, we earned net income of $5.0 million, or $1.15 basic net income per share, which was a 14.4% increase over 2004 net income of $4.4 million or $1.03 basic net income per share. We believe strategic pricing of both our loans and deposits improved our net interest margin by managing our overall cost of funds and allowing us to attract the higher balance, higher quality loans in our markets.  The resulting $3.5 million, or 21.9%, increase in net interest income absorbed a 16.1% increase in non-interest expense for 2005 over the prior year.  A full year of operating two new offices contributed to increased salaries and benefits, occupancy and equipment and other operating costs.  In addition to the new offices, rising costs in employee benefits also contributed to increased personnel expense.  Compliance costs related to the Sarbanes-Oxley Act of 2002 also increased costs for outside professional services.





24



---





Net Interest Income



Net interest income increased to $19.4 million in 2005, with a net yield of 4.63%, compared to $15.9 million and a net yield of 4.56% in 2004, which was an increase of $3.5 million, or 7 basis points, from 2004.  The increase in net interest income primarily was generated by an increased volume of $11.7 million in average net interest-earning assets, which produced $3.5 million in net interest income.  The additional interest income over interest expense was driven by strong loan demand in a rising rate environment, acquisition of higher yielding investments as well as an increase of $10.0 million in average non-interest-bearing demand deposits.  Also contributing to the increase in net interest income was the positive results of repricing our interest-earning assets faster than our interest-bearing funds in a rising rate environment, producing an additional $630,000 in net interest income.  The rates earned on a substantial portion of our loans reprice to correspond with each prime rate increase.  Most of our interest-bearing liabilities, however, have fixed interest rates until maturity and as a result do not reprice as quickly or in the same increments as our loan portfolio.  The national prime increased 200 basis points during 2005 to 7.25% at December 31, 2005 from 5.25% at January 1, 2005.



On average, interest-earning assets grew $69.7 million during 2005 over the prior year period.  A substantial portion of the increase in interest-earning assets was achieved through increased loan demand.  Average loans increased $52.3 million during 2005 over the prior year to $351.1 million, generating additional interest income of $3.7 million. Rising interest rates generated additional interest income of $2.9 million on the banks loan portfolio. An increase in volume of interest-bearing liabilities of $58.0 million resulted in additional interest expense of $1.3 million while repricing due to rising interest rates increased interest expense by $2.9 million.  The increase in interest expense primarily resulted from a $29.9 million increase in higher costing jumbo time deposits at an average rate paid on these deposits of 3.27%.  However, an increase of $12.9 million in lower costing savings deposits at an average rate paid of 2.23% and an increase of $10.0 million in interest free demand deposits partially offset the increased cost of the jumbo time deposits.





Provision for Loan Losses and Asset Quality



Our provision for loan losses was $1.4 million during 2005 and $1.6 million during 2004.  Net charge-offs in 2005 declined to $493,000 compared to $971,000 in 2004. As a percent of average loans, net charge-offs were 0.14%, the lowest level in the five years prior to 2005.  The lower level of net-charge-offs and nonperforming assets is attributable to continued efforts to improve asset quality, including improved underwriting.



Our non-performing assets, which consist of loans past due 90 days or more, real estate acquired in the settlement of loans, and loans in nonaccrual status, decreased from $1.6 million at December 31, 2004 to $1.3 million at December 31, 2005.  Our allowance for loan losses, expressed as a percentage of gross loans, was 1.25% and 1.30% at December 31, 2005 and 2004, respectively.  At December 31, 2005, the allowance for loan losses amounted to $5.0 million, which management believes is adequate to absorb losses inherent in its loan portfolio.



Non-interest Income



Non-interest income before gains and losses on sales of securities, loans and loss on hedges increased $93,000, or 2.5%, from $3.7 million during 2004 to $3.8 million in 2005. Our non-interest income is comprised primarily of service charges on deposit accounts, financial services commissions, merchant fees, bank-owned life insurance income and various other sources of miscellaneous operating income.  Fees charged on deposit accounts, our largest component of non-interest income, declined $66,000 for 2005 compared to 2004.  These fees have been trending downward as competition for deposits by offering lower fees on deposit accounts continues among banking institutions in our market areas.  Merchant fees increased $42,000 from $347,000 during 2004 to $389,000 in 2005, primarily due to increased customer use of debit cards.  During the same period, other service charges, commissions and fees increased $211,000, of which $31,000 was attributable to increased profits from our investment in Four Oaks Mortgage Company, L.P., $39,000 was attributable to increased commissions from our financial services department and $81,000 was attributable to increased credit card interchange and stored value card fees.  Income from bank-owned life insurance decreased $94,000. Net losses of $386,000 on sales of investment securities were recognized in 2005 in efforts to position our investment portfolio for higher yielding securities in a rising interest rate environment.  A loss of $397,000 for 2005 was recognized due to the elimination of the fair value hedge accounting adjustments in net income for 2005.  Net gains of $71,000 from sales of investment securities were recognized during 2004. Our net gains on sales of loans continued to trend downward during 2005 with net gains of $61,000 recorded compared to $72,000 during 2004 and $212,000 during 2003.  The decline in loan sales was attributable to a slow down in funding of government-backed loans.



25



---







Non-interest Expense



Our non-interest expense increased from $11.5 million in 2004 to $13.4 million in 2005, an increase of $1.8 million. Although non-interest expense continues to increase, our non-interest expense as a percent of our average assets has declined over the last five years, down to below 3.0% for 2005, our lowest level in the five years prior to 2005.  Approximately 51.3% of the $1.8 million increase in non-interest expense over 2004 was due to increases in salaries and benefits.  Salaries increased 12.7% while employee benefits increased 25.9%, primarily due to increased employee insurance costs.  In addition to normal salary increases and increased costs for employee benefits overall, personnel costs grew due to additional staffing needs throughout the bank.  In total, our number of full time equivalent employees grew from 131 employees for 2004, up to 135 employees for 2005. The increased personnel costs reflect the costs of a full year of staffing two new offices which opened in January 2005.  In addition to personnel costs, additional costs during the year were incurred in occupancy and equipment due to the additional staff, the opening of the new offices, as well as general upgrades in technology throughout the bank. For 2005, occupancy and equipment expense increased $41,000 and $90,000, respectively, over the prior year. Additional testing and documentation required for compliance with the Sarbanes-Oxley Act of 2002 continued to increase our fees paid for outside professional services in 2005, contributing to an increase of $218,000 in professional and consulting fees over 2004.  Other operating expenses were up due to general asset growth and the increased costs due to additional staffing and new offices opened. The primary increases in other non-interest expense for 2005 over the prior year period included materials, training and seminars, up $40,000, advertising expense, up $62,000, printing and office supplies, up $39,000, postage and freight up $62,000, telephone expense up $13,000, checks, forgery and other losses up $46,000, auto expense up $35,000, waived charges up $73,000 and directors fees up $52,000. There were no other significant increases in the remaining other non-interest expense categories.





Liquidity and Capital Resources



Our liquidity position is primarily dependent upon the banks need to respond to loan demand, the short-term demand for funds caused by withdrawals from deposit accounts (other than time deposits) and the liquidity of its assets.  The banks primary liquidity sources include cash and amounts due from other banks, U.S Government Agency and other short-term investment securities.  In addition, the bank has the ability to borrow funds from the Federal Reserve Bank and the Federal Home Loan Bank of Atlanta (FHLB), to purchase federal funds from other financial institutions, to obtain wholesale deposits, and repurchase agreements. At December 31, 2006, the bank had available lines of credit totaling $51.6 million with the FHLB and $29.3 million lines of credit from various financial institutions to purchase federal funds.  As of December 31, 2006, we have and an outstanding commitment to construct a new branch facility in Zebulon at an estimated cost of $1.2 million. Management believes that our liquidity sources are adequate to meet our operating needs and the operating needs of the bank for the next eighteen months. Total shareholders equity was $49.3 million, or 8.11% of total assets at December 31, 2006, and $41.6 million or 7.96% of total assets at December 31, 2005.



Off-Balance Sheet Arrangements



As part of its normal course of business to meet the financing needs of its customers, the bank is at times a party to financial instruments with off-balance sheet credit risk.  Such instruments include commitments to extend credit and standby letters of credit. At December 31, 2006, the banks outstanding commitments to extend credit consisted of undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit of $145.2 million. Additional detail regarding the banks off-balance sheet risk exposure is presented in Note J to the accompanying consolidated financial statements.





26



---





Interest Rate Sensitivity Analysis



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



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



|                                              |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |         |        
|--------------------------------------------- | --------------------------------------------- | ---------------------------------- | ------------------------------------------------- | ------- | ------------- | ------- | ------------ | -------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | -------
|                                              |                                               |                                    | Interest Rate Sensitivity as of December 31, 2006
|                                              |                                               |                                    | 3 Months                                          |         | Over 3 Months |         | Total Within |          | Over 12 |         |         |        
|                                              |                                               |                                    | or Less                                           |         | to 12 Months  |         | 12 Months    |          | Months  |         | Total  
|Interest-earning assets:                      |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |        
|                                              | Loans                                         | $                                  | 223,620                                           |         | $             | 29,685  |              | $        | 253,305 |         | $       | 208,458 |         | $       | 461,763
|                                              | Securities available for sale                 |                                    | -                                                 |         |               | 2,630   |              |          | 2,630   |         |         | 98,763  |         |         | 101,393
|                                              | Other earning assets                          |                                    | 3,751                                             |         |               | -       |              |          | 3,751   |         |         | 4,194   |         |         | 7,945  
|                                              |                                               | Total interest-earning assets      | $                                                 | 227,371 |               | $       | 32,315       |          | $       | 259,686 |         | $       | 311,415 |         | $       | 571,101
|                                              |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |         |        
|                                              | Percent of total interest-earning assets      |                                    | 39.81%                                            |         |               | 5.66%   |              |          | 45.47%  |         |         | 54.53%  |         |         | 100.00%
|                                              | Cumulative percent of total interest-         |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |        
|                                              | earning assets                                |                                    | 39.81%                                            |         |               | 45.47%  |              |          | 45.47%  |         |         | 100.00% |         |         | 100.00%
|                                              |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |         |        
|Interest-bearing liabilities:                 |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |        
|                                              | Fixed maturity deposits                       | $                                  | 63,213                                            |         | $             | 153,960 |              | $        | 217,173 |         | $       | 56,569  |         | $       | 273,742
|                                              | All other deposits                            |                                    | 121,039                                           |         |               | -       |              |          | 121,039 |         |         | -       |         |         | 121,039
|                                              | Borrowings                                    |                                    | 3,400                                             |         |               | -       |              |          | 3,400   |         |         | 70,000  |         |         | 73,400 
|                                              |                                               | Total interest-bearing liabilities | $                                                 | 187,652 |               | $       | 153,960      |          | $       | 341,612 |         | $       | 126,569 |         | $       | 468,181
|                                              |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |         |        
|                                              | Percent of total interest-bearing liabilities |                                    | 40.08%                                            |         |               | 32.88%  |              |          | 72.97%  |         |         | 27.03%  |         |         | 100.00%
|                                              | Cumulative percent of total interest-         |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |        
|                                              | bearing liabilities                           |                                    | 40.08%                                            |         |               | 72.97%  |              |          | 72.97%  |         |         | 100.00% |         |         | 100.00%
|                                              |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |         |         |        
|Interest sensitivity gap                      | $                                             | 39,719                             |                                                   | $       | (121,645)     |         | $            | (81,926) |         | $       | 184,846 |         | $       | 102,920
|Cumulative interest sensitivity gap           |                                               | 39,719                             |                                                   |         | (81,926)      |         |              | (81,926) |         |         | 102,920 |         |         | 102,920
|Cumulative interest sensitivity gap as a      |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |        
|percent of total interest-earning assets      |                                               | 6.95%                              |                                                   |         | (14.35%)      |         |              | (14.35%) |         |         | 18.02%  |         |         | 18.02% 
|Cumulative ratio of interest-sensitive assets |                                               |                                    |                                                   |         |               |         |              |          |         |         |         |         |         |        
|to interest-sensitive liabilities             |                                               | 121.17%                            |                                                   |         | 76.02%        |         |              | 76.02%   |         |         | 121.98% |         |         | 121.98%





27



---







Contractual Obligations and Commitments



In the normal course of business there are various outstanding contractual obligations that require future cash outflows.  The following table shows our expected contractual obligations and future operating lease commitments as of December 31, 2006 (in thousands):



|                    |                        |         |        |           |           |  |           |        |         |   |        |           |   |       
|------------------- | ---------------------- | ------- | ------ | --------- | --------- |  | --------- | ------ | ------- | - | ------ | --------- | - | ------
|                    | Payments Due by Period
|                    |                        |         |        |           |           |  |           |        |         |   |        |           |   |       
|                    |                        |         |        | Less than |           |  |           |        |         |   |        | More than
|                    | Total                  |         | 1 year |           | 1-3 years |  | 3-5 years |        | 5 years
|Borrowings          | $                      | 73,400  |        | $         | 3,400     |  | $         | 10,000 |         | $ | 18,000 |           | $ | 42,000
|Operating leases    |                        | 1,013   |        |           | 123       |  |           | 201    |         |   | 185    |           |   | 504   
|Building obligation |                        | 1,157   |        |           | 1,157     |  |           | -      |         |   | -      |           |   | -     
|Deposits            |                        | 273,742 |        |           | 217,172   |  |           | 54,381 |         |   | 2,189  |           |   | -     
|Total               | $                      | 349,312 |        | $         | 221,852   |  | $         | 64,582 |         | $ | 20,374 |           | $ | 42,504



The following table shows our undisbursed lines of credit, other commitments to extend, undisbursed portion of construction loans and stand-by letters of credit as of December 31, 2006 (in thousands):



|                                          |                                            |         |        |           |           |  |           |        |         |   |       |           |   |       
|----------------------------------------- | ------------------------------------------ | ------- | ------ | --------- | --------- |  | --------- | ------ | ------- | - | ----- | --------- | - | ------
|                                          | Amount of Commitment Expiration Per Period
|                                          |                                            |         |        |           |           |  |           |        |         |   |       |           |   |       
|                                          |                                            |         |        | Less than |           |  |           |        |         |   |       | More than
|                                          | Total                                      |         | 1 year |           | 1-3 years |  | 3-5 years |        | 5 years
|Undisbursed lines of credit               | $                                          | 26,948  |        | $         | 210       |  | $         | 8,207  |         | $ | 863   |           | $ | 17,688
|Other commitments to extend               |                                            | 42,471  |        |           | 30,410    |  |           | 11,506 |         |   | 145   |           |   | 410   
|Undisbursed portion of construction loans |                                            | 71,120  |        |           | 65,689    |  |           | 5,405  |         |   | 26    |           |   | -     
|Stand-by letters of credit                |                                            | 4,711   |        |           | 4,254     |  |           | 283    |         |   | 174   |           |   | -     
|                                          |                                            |         |        |           |           |  |           |        |         |   |       |           |   |       
|Total                                     | $                                          | 145,250 |        | $         | 100,563   |  | $         | 25,401 |         | $ | 1,208 |           | $ | 18,078





Inflation



The effect of inflation on financial institutions differs somewhat from the effect it has on other businesses.  The performances of banks, with assets and liabilities that are primarily monetary in nature, are affected more by changes in interest rates than by inflation.  Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.  During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans and deposits.  Also, general increases in the price of goods and services will generally result in increased operating expenses.



Income Taxes



Income taxes, as a percentage of income before income taxes, for 2006 and 2005 were 34.08% and 35.37%, respectively.  The decrease was the result of managements redirection of funds between loans and different types of taxable and tax exempt interest-bearing assets in response to economic conditions and the banks liquidity requirements.



Distribution of Assets, Liabilities and Shareholders Equity; Interest Rates and Interest Differential



The following schedule presents average balance sheet information for the years 2006, 2005 and 2004, along with related interest earned and average yields for interest-earning assets and the interest paid and average rates for interest-bearing liabilities.  Nonaccrual notes are included in loan amounts.



28



---













|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|--------------------------------------------------------------------------------- | -------------------------------- | ------- | -------- | - | ------ | ------- | ------- | ------- | -------- | ------- | ---- | ------- | ------- | ------- | ----- | -------- | - | ------- |  | - | ------ |  | -----
|                                                                                  | For the Years Ended December 31,
|                                                                                  | 2006                             |         | 2005     |   | 2004  
|                                                                                  | Average                          |         |          |   |        | Average |         | Average |          |         |      | Average |         | Average |       | Average  |   |        
|                                                                                  | balance                          |         | Interest |   | rate   |         | balance |         | Interest |         | Rate |         | balance |         |       | Interest |   | Rate   
|                                                                                  | (dollars in thousands)           |         |          |   |        |         |         |         |         
|Interest-earning assets:                                                          |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Loans                                                                             | $                                | 426,768 |          | $ | 35,457 |         | 8.31%   |         | $        | 351,103 |      | $       | 26,612  |         | 7.58% |          | $ | 298,783 |  | $ | 19,968 |  | 6.68%
|Investment securities - taxable                                                   |                                  | 89,195  |          |   | 4,503  |         | 5.05%   |         |          | 57,242  |      |         | 2,389   |         | 4.17% |          |   | 40,729  |  |   | 1,470  |  | 3.61%
|Investment securities - tax-exempt                                                |                                  | 4,123   |          |   | 152    |         | 3.69%   |         |          | 3,175   |      |         | 118     |         | 3.72% |          |   | 4,278   |  |   | 162    |  | 3.79%
|Other                                                                             |                                  | 7,970   |          |   | 444    |         | 5.57%   |         |          | 7,787   |      |         | 285     |         | 3.66% |          |   | 5,806   |  |   | 148    |  | 2.55%
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Total interest-earning assets                                                     |                                  | 528,056 |          |   | 40,556 |         | 7.68%   |         |          | 419,307 |      |         | 29,404  |         | 7.01% |          |   | 349,546 |  |   | 21,748 |  | 6.22%
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Other assets                                                                      |                                  | 32,633  |          |   |        |         |         |         |          | 30,155  |      |         |         |         |       |          |   | 26,826  |  |   |        |  |      
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Total assets                                                                      | $                                | 560,689 |          |   |        |         |         |         | $        | 449,462 |      |         |         |         |       |          | $ | 376,422 |  |   |        |  |      
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Interest-bearing liabilities:                                                     |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Deposits:                                                                         |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|NOW and money market                                                              | $                                | 71,981  |          |   | 2,079  |         | 2.89%   |         | $        | 57,928  |      |         | 808     |         | 1.39% |          | $ | 52,677  |  |   | 361    |  | 0.69%
|Savings                                                                           |                                  | 37,304  |          |   | 1,079  |         | 2.89%   |         |          | 26,858  |      |         | 599     |         | 2.23% |          |   | 13,967  |  |   | 59     |  | 0.42%
|Time deposits greater than $100,000                                               |                                  | 157,497 |          |   | 6,961  |         | 4.42%   |         |          | 124,248 |      |         | 4,066   |         | 3.27% |          |   | 94,313  |  |   | 1,978  |  | 2.10%
|Other time deposits                                                               |                                  | 96,058  |          |   | 4,083  |         | 4.25%   |         |          | 80,610  |      |         | 2,350   |         | 2.91% |          |   | 78,987  |  |   | 1,725  |  | 2.18%
|Borrowings                                                                        |                                  | 63,885  |          |   | 2,989  |         | 4.68%   |         |          | 51,154  |      |         | 2,160   |         | 4.22% |          |   | 42,799  |  |   | 1,688  |  | 3.94%
|Subordinated debentures                                                           |                                  | 9,389   |          |   | 626    |         | 6.67%   |         |          | -       |      |         | -       |         | -     |          |   | -       |  |   | -      |  | -    
|Total interest-bearing liabilities                                                |                                  | 436,114 |          |   | 17,817 |         | 3.51%   |         |          | 340,798 |      |         | 9,983   |         | 2.93% |          |   | 282,743 |  |   | 5,811  |  | 2.06%
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Non-interest-bearing deposits                                                     |                                  | 73,151  |          |   |        |         |         |         |          | 65,570  |      |         |         |         |       |          |   | 55,580  |  |   |        |  |      
|Other liabilities                                                                 |                                  | 5,883   |          |   |        |         |         |         |          | 3,481   |      |         |         |         |       |          |   | 2,964   |  |   |        |  |      
|Shareholders equity                                                              |                                  | 45,541  |          |   |        |         |         |         |          | 39,613  |      |         |         |         |       |          |   | 35,135  |  |   |        |  |      
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Total liabilities and shareholders equity                                        | $                                | 560,689 |          |   |        |         |         |         | $        | 449,462 |      |         |         |         |       |          | $ | 376,422 |  |   |        |  |      
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Net interest income and interest rate spread                                      |                                  |         |          | $ | 22,739 |         | 4.17%   |         |          |         |      | $       | 19,423  |         | 4.08% |          |   |         |  | $ | 15,937 |  | 4.16%
|Net yield on average interest-earning assets                                      |                                  |         |          |   |        |         | 4.31%   |         |          |         |      |         |         |         | 4.63% |          |   |         |  |   |        |  | 4.56%
|                                                                                  |                                  |         |          |   |        |         |         |         |          |         |      |         |         |         |       |          |   |         |  |   |        |  |      
|Ratio of average interest-earning assets to average interest-bearing  liabilities |                                  | 121.08% |          |   |        |         |         |         |          | 123.04% |      |         |         |         |       |          |   | 123.64% |  |   |        |  |      



The following table shows changes in interest income and expense by category and rate/volume variances for the years ended December 31, 2006 and 2005. The changes due to rate and volume were allocated on their absolute values:



29



---









|                                    |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|----------------------------------- | ------------------------------------- | ----- | ------------------------------------- | - | ----- |  | ------ | ------ | ---- | - | ----- |  | - | ----- |  | - | -----
|                                    | Year Ended
December 31, 2006 vs. 2005 |       | Year Ended
December 31, 2005 vs. 2004
|                                    | Increase (Decrease) Due to            |       | Increase (Decrease) Due to           
|                                    | Volume                                |       | Rate                                  |   | Total |  | Volume |        | Rate |   | Total
|                                    | (In thousands)                       
|Interest income:                    | $                                     | 6,011 |                                       | $ | 2,834 |  | $      | 8,845  |      | $ | 3,730 |  | $ | 2,914 |  | $ | 6,644
|Loans                               |                                       | 1,473 |                                       |   | 641   |  |        | 2,114  |      |   | 643   |  |   | 276   |  |   | 919  
|Investment securities - taxable     |                                       | 35    |                                       |   | (1)   |  |        | 34     |      |   | (41)  |  |   | (3)   |  |   | (44) 
|Investment securities - tax-exempt  |                                       | 10    |                                       |   | 149   |  |        | 159    |      |   | 62    |  |   | 75    |  |   | 137  
|Other                               |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|                                    |                                       | 7,529 |                                       |   | 3,623 |  |        | 11,152 |      |   | 4,394 |  |   | 3,262 |  |   | 7,656
|Total interest income               |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|                                    |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|Interest expense:                   |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|Deposits:                           |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|NOW and money market                |                                       | 301   |                                       |   | 970   |  |        | 1,271  |      |   | 55    |  |   | 392   |  |   | 447  
|Savings                             |                                       | 268   |                                       |   | 212   |  |        | 480    |      |   | 171   |  |   | 369   |  |   | 540  
|Time deposits greater than $100,000 |                                       | 1,279 |                                       |   | 1,615 |  |        | 2,894  |      |   | 804   |  |   | 1,284 |  |   | 2,088
|Other time deposits                 |                                       | 552   |                                       |   | 1,182 |  |        | 1,735  |      |   | 41    |  |   | 583   |  |   | 624  
|Borrowings                          |                                       | 567   |                                       |   | 262   |  |        | 829    |      |   | 341   |  |   | 131   |  |   | 472  
|Subordinated debentures             |                                       | 626   |                                       |   | -     |  |        | 626    |      |   | -     |  |   | -     |  |   | -    
|                                    |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|Total interest expense              |                                       | 3,593 |                                       |   | 4,241 |  |        | 7,834  |      |   | 1,412 |  |   | 2,759 |  |   | 4,171
|                                    |                                       |       |                                       |   |       |  |        |        |      |   |       |  |   |       |  |   |      
|Net interest income increase        | $                                     | 3,936 |                                       | $ | (618) |  | $      | 3,318  |      | $ | 2,982 |  | $ | 503   |  | $ | 3,485





Market Risk



Like most financial institutions, our most significant market risk exposure is the risk of economic loss resulting from adverse changes in market price and interest rates.  This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.  Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities.  The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income.  We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk.  Interest rate risk is monitored as part of the banks asset/liability management function. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments we considered market risk sensitive as of December 31, 2006. Loans include nonaccrual loans but not the allowance for loan losses. (dollars in thousands).



30



---











|                       |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |           |         |        
|---------------------- | -------------------------------------- | ------------- | ------- | ------- | ---- | ------ | ------ | - | ------ | ------ | ---- | ------ | ---------- | - | ------ | ------ | ------------- | ------ | ---------- | - | ------- | ------- | ------- | ----- | --------- | ------- | -------
|                       |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               | Beyond |            |   |         |         | Average |       | Estimated
|                       |                                        |               | 2007    |         | 2008 |        | 2009   |   | 2010   |        | 2011 |        | Five Years |   | Total  |        | Interest Rate |        | Fair Value
|                       |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |           |         |        
|Financial assets:      |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |          
|                       | Loans:                                 |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |           |        
|                       |                                        | Fixed rate    | $       | 44,036  |      | $      | 54,356 |   | $      | 52,305 |      | $      | 36,739     |   | $      | 52,507 |               | $      | 11,653     |   | $       | 251,596 |         | 7.36% |           | $       | 247,975
|                       |                                        | Variable Rate |         | 210,167 |      |        | -      |   |        | -      |      |        | -          |   |        | -      |               |        | -          |   |         | 210,167 |         | 8.96% |           |         | 207,142
|                       | Securities available for sale          |               | 3,682   |         |      | 3,934  |        |   | 7,137  |        |      | 22,154 |            |   | 2,495  |        |               | 61,991 |            |   | 101,393 |         | 5.10%   |       |           | 101,483
|                       | Other earning assets                   |               | 3,751   |         |      | -      |        |   | -      |        |      | -      |            |   | -      |        |               | -      |            |   | 3,751   |         | 4.09%   |       |           | 3,751  
|                       |                                        | Total         | $       | 261,636 |      | $      | 58,290 |   | $      | 59,442 |      | $      | 58,893     |   | $      | 55,002 |               | $      | 73,644     |   | $       | 566,907 |         | 7.53% |           | $       | 560,351
|                       |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |           |         |        
|                       |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |           |         |        
|Financial liabilities: |                                        |               |         |         |      |        |        |   |        |        |      |        |            |   |        |        |               |        |            |   |         |         |         |       |          
|                       | Money market, NOW and savings deposits | $             | 121,039 |         |      | -      |        |   | -      |        |      | -      |            |   | -      |        |               | -      |            | $ | 121,039 |         | 1.94%   |       | $         | 113,758
|                       | Time deposits                          |               | 217,338 |         | $    | 8,486  |        | $ | 18,963 |        | $    | 26,766 |            | $ | 2,189  |        | $             | -      |            |   | 273,742 |         | 4.75%   |       |           | 275,700
|                       | Borrowings                             |               | 3,400   |         |      | 10,000 |        |   | -      |        |      | 10,000 |            |   | 8,000  |        |               | 42,000 |            |   | 73,400  |         | 4.65%   |       |           | 74,042 
|                       | Subordinated debentures                |               | -       |         |      | -      |        |   | -      |        |      | -      |            |   | 12,372 |        |               | -      |            |   | 12,372  |         | 5.06%   |       |           | 12,384 
|                       |                                        | Total         | $       | 341,777 |      | $      | 18,486 |   | $      | 18,963 |      | $      | 36,766     |   | $      | 22,561 |               | $      | 42,000     |   | $       | 480,553 |         | 3.90% |           | $       | 475,884





Derivative Financial Instruments



A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or reference rate.  These instruments primarily consist of interest rate swaps, caps, floors, financial forward and futures contracts and options written or purchased.  Derivative contracts are written in amounts referred to as notional amounts.  Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between parties and are not a measure of financial risk.  Credit risk arises when amounts receivable from a counterparty exceed amounts payable.  We control our risk of loss on derivative contracts by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit.



We have used interest rate swaps in the management of interest rate risk.  Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments.  A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions.  Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another.  At December 31, 2006, swap derivatives with a total notional value of $63.6 million, with terms ranging up to five years, were outstanding.



Although off-balance sheet derivative financial instruments do not expose us to credit risk equal to the notional amount, such agreements generate credit risk to the extent of the fair value gain in an off-balance sheet derivative financial instrument if the counterparty fails to perform.  We minimize such risk by evaluating the creditworthiness of the counterparties and consistently monitoring these agreements.  The counterparties to these arrangements are primarily large commercial banks and investment banks.  Where appropriate, master netting agreements are arranged or collateral is obtained in the form of rights to securities.  At December 31, 2006, our interest rate swaps reflected a net unrealized loss of $145,000.







31



---





Other risks associated with interest-sensitive derivatives include the effect on fixed rate positions during periods of changing interest rates.  Indexed amortizing swaps notional amounts and maturities change based on certain interest rate indices.  Generally, as rates fall the notional amounts decline more rapidly, and as rates increase notional amounts decline more slowly.  As of December 31, 2006, we had no indexed amortizing swaps outstanding. Under unusual circumstances, financial derivatives also increase liquidity risk, which could result from an environment of rising interest rates in which derivatives produce negative cash flows while being offset by increased cash flows from variable rate loans.  We consider such risk to be insignificant due to the relatively small derivative positions we hold.



A discussion of derivatives is presented in Note J to our consolidated financial statements, which are presented under Item 8 of Part II in this Form 10-K.



Quarterly Financial Information

The following table, sets forth, for the periods indicated, certain of our consolidated quarterly financial information.  This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments that management considers necessary for a fair presentation of the results for such periods.  This information should be read in conjunction with our consolidated financial statements included under Item 8 of Part II in this Form 10-K.  The results for any quarter are not necessarily indicative of results for any future period. (dollars in thousands, except per share data).



|                        |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |      |      
|----------------------- | ----------------------------------- | ---------------------------- | ------ | ---------------------------- | ---- | ------- |  | ------- | ----- | ------- | ---- | ------- |  | ------- | ----- | ------- | ---- | ----- |  | ---- | ----- |  | ---- | -----
|                        |                                     | Year Ended December 31, 2006 |        | Year Ended December 31, 2005
|                        |                                     | Fourth                       |        | Third                        |      | Second  |  | First   |       | Fourth  |      | Third   |  | Second  |       | First  
|                        |                                     | Quarter                      |        | Quarter                      |      | Quarter |  | Quarter |       | Quarter |      | Quarter |  | Quarter |       | Quarter
|Operating Data:         |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |     
|                        | Total interest income               | $                            | 11,097 |                              | $    | 10,547  |  | $       | 9,673 |         | $    | 9,239   |  | $       | 8,507 |         | $    | 7,766 |  | $    | 6,908 |  | $    | 6,223
|                        | Total interest expense              |                              | 5,283  |                              |      | 4,762   |  |         | 4,176 |         |      | 3,596   |  |         | 3,137 |         |      | 2,724 |  |      | 2,225 |  |      | 1,897
|                        | Net interest income                 |                              | 5,814  |                              |      | 5,785   |  |         | 5,497 |         |      | 5,643   |  |         | 5,370 |         |      | 5,042 |  |      | 4,683 |  |      | 4,326
|                        | Provision for loan losses           |                              | 187    |                              |      | 332     |  |         | 168   |         |      | 186     |  |         | 527   |         |      | 498   |  |      | 191   |  |      | 187  
|                        | Net interest income after provision |                              | 5,627  |                              |      | 5,453   |  |         | 5,329 |         |      | 5,457   |  |         | 4,843 |         |      | 4,544 |  |      | 4,492 |  |      | 4,139
|                        | Non-interest income                 |                              | 835    |                              |      | 1,656   |  |         | 861   |         |      | 923     |  |         | 558   |         |      | 731   |  |      | 1,315 |  |      | 473  
|                        | Non-interest expense                |                              | 4,313  |                              |      | 3,889   |  |         | 3,786 |         |      | 3,509   |  |         | 3,393 |         |      | 3,358 |  |      | 3,408 |  |      | 3,195
|                        | Income before income taxes          |                              | 2,149  |                              |      | 3,220   |  |         | 2,404 |         |      | 2,871   |  |         | 2,008 |         |      | 1,917 |  |      | 2,399 |  |      | 1,417
|                        | Provision for income taxes          |                              | 653    |                              |      | 1,074   |  |         | 869   |         |      | 1,031   |  |         | 703   |         |      | 700   |  |      | 860   |  |      | 475  
|                        | Net income                          | $                            | 1,496  |                              | $    | 2,146   |  | $       | 1,535 |         | $    | 1,840   |  | $       | 1,305 |         | $    | 1,217 |  | $    | 1,539 |  | $    | 942  
|                        |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |      |      
|Per Share Data:         |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |     
|Net income:             |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |     
|                        | Basic                               | $                            | 0.27   |                              | $    | 0.39    |  | $       | 0.28  |         | $    | 0.34    |  | $       | 0.24  |         | $    | 0.22  |  | $    | 0.28  |  | $    | 0.17 
|                        | Diluted                             |                              | 0.27   |                              |      | 0.38    |  |         | 0.28  |         |      | 0.33    |  |         | 0.23  |         |      | 0.22  |  |      | 0.28  |  |      | 0.17 
|                        |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |      |      
|Cash dividends declared |                                     | 0.07                         |        |                              | 0.06 |         |  | 0.06    |       |         | 0.06 |         |  | 0.06    |       |         | 0.06 |       |  | 0.06 |       |  | 0.06
|                        |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |      |      
|Common stock price:     |                                     |                              |        |                              |      |         |  |         |       |         |      |         |  |         |       |         |      |       |  |      |       |  |     
|                        | High                                | $                            | 28.00  |                              | $    | 24.00   |  | $       | 27.20 |         | $    | 19.80   |  | $       | 20.00 |         | $    | 19.20 |  | $    | 18.56 |  | $    | 15.36
|                        | Low                                 |                              | 23.60  |                              |      | 19.80   |  |         | 19.40 |         |      | 17.40   |  |         | 15.84 |         |      | 15.84 |  |      | 14.91 |  |      | 14.08







32



---





Investment Portfolio



The valuations of investment securities at December 31, 2006, 2005 and 2004, respectively, were as follows (in thousands):



|                                      |                    |         |            |   |           |  |            |        |           |   |            |  |   |        |  |   |       
|------------------------------------- | ------------------ | ------- | ---------- | - | --------- |  | ---------- | ------ | --------- | - | ---------- |  | - | ------ |  | - | ------
|                                      | Available for Sale
|                                      | 2006               |         | 2005       |   | 2004     
|                                      | Amortized          |         | Estimated  |   | Amortized |  | Estimated  |        | Amortized |   | Estimated 
|                                      | cost               |         | fair value |   | cost      |  | fair value |        | cost      |   | fair value
|                                      |                    |         |            |   |           |  |            |        |           |   |            |  |   |        |  |   |       
|U.S. Government and agency securities | $                  | 85,730  |            | $ | 85,247    |  | $          | 69,108 |           | $ | 68,431     |  | $ | 34,991 |  | $ | 34,958
|State and municipal securities        |                    | 4,623   |            |   | 4,609     |  |            | 3,963  |           |   | 3,910      |  |   | 3,573  |  |   | 3,632 
|Mortgage-backed securities            |                    | 9,882   |            |   | 9,860     |  |            | 7,003  |           |   | 6,904      |  |   | 12,759 |  |   | 12,775
|Other                                 |                    | 1,441   |            |   | 1,677     |  |            | 685    |           |   | 964        |  |   | 628    |  |   | 977   
|                                      |                    |         |            |   |           |  |            |        |           |   |            |  |   |        |  |   |       
|Total securities                      | $                  | 101,676 |            | $ | 101,393   |  | $          | 80,759 |           | $ | 80,209     |  | $ | 51,951 |  | $ | 52,342
|                                      |                    |         |            |   |           |  |            |        |           |   |            |  |   |        |  |   |       
|Pledged securities                    |                    |         |            | $ | 69,239    |  |            |        |           | $ | 65,159     |  |   |        |  | $ | 33,408





The following table sets forth the carrying value of our available for sale investment portfolio at December 31, 2006 (in thousands):





|                                      |                |       |         |              |          |               |          |        |       |   |        |  |   |        
|------------------------------------- | -------------- | ----- | ------- | ------------ | -------- | ------------- | -------- | ------ | ----- | - | ------ |  | - | -------
|                                      | Carrying Value
|                                      |                |       |         | After 1 year |          | After 5 years |          |        |       |   |        | 
|                                      |                |       |         | through      |          | through       |          | After  |       |   |       
|                                      | 1 year         |       | 5 years |              | 10 years |               | 10 years |        | Total
|U.S. Government and agency securities | $              | 1,984 |         | $            | 34,864   |               | $        | 49,759 |       | $ | -      |  | $ | 86,607 
|State and municipal securities        |                | -     |         |              | 855      |               |          | 1,026  |       |   | 2,728  |  |   | 4,609  
|Mortgage-backed securities            |                | -     |         |              | -        |               |          | 669    |       |   | 7,831  |  |   | 8,500  
|Other                                 |                | -     |         |              | -        |               |          | -      |       |   | 1,677  |  |   | 1,677  
|                                      |                |       |         |              |          |               |          |        |       |   |        |  |   |        
|Total                                 | $              | 1,984 |         | $            | 35,719   |               | $        | 51,454 |       | $ | 12,236 |  | $ | 101,393





The following table sets forth the weighted average yield by maturity of our available for sale investment portfolio at December 31, 2006 amortized cost:





|                                      |                         |  |              |  |               |  |          |  |      
|------------------------------------- | ----------------------- |  | ------------ |  | ------------- |  | -------- |  | -----
|                                      | Weighted Average Yields
|                                      |                         |  | After 1 year |  | After 5 years |  |          |  |      
|                                      |                         |  | through      |  | through       |  | After    |  |      
|                                      | 1 year                  |  | 5 years      |  | 10 years      |  | 10 years |  | Total
|U.S. Government and agency securities | 4.27%                   |  | 4.50%        |  | 5.60%         |  | -        |  | 5.13%
|                                      | -                       |  | 4.02%        |  | 3.36%         |  | 3.69%    |  | 3.70%
|State and municipal securities        | -                       |  | -            |  | 4.50%         |  | 5.19%    |  | 5.13%
|Mortgage-backed securities            | -                       |  | -            |  | -             |  | 4.71%    |  | 4.71%
|Other                                 |                         |  |              |  |               |  |          |  |      
|                                      |                         |  |              |  |               |  |          |  |      
|Total weighted average yields         | 4.27%                   |  | 4.49%        |  | 5.54%         |  | 4.76%    |  | 5.03%





33



---





Loan Portfolio



Loans consisted of the following, as extracted from the Call Reports of December 31, 2006, 2005, 2004, 2003 and 2002 (in thousands):



|                                                 |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |         |         |         |       
|------------------------------------------------ | --------------------------------------------- | ------------------------------ | --------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------
|                                                 |                                               |                                |           | 2006    |         | 2005    |         | 2004    |         | 2003    |         | 2002   
|Loans receivable:                                |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |        
|Loans secured by real estate:                    |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |        
|                                                 | Construction and land development             | $                              | 194,460   |         | $       | 142,592 |         | $       | 90,742  |         | $       | 66,242  |         | $       | 56,780 
|                                                 | Secured by farmland                           |                                | 12,326    |         |         | 11,650  |         |         | 15,203  |         |         | 13,384  |         |         | 8,290  
|                                                 | Secured by 1-4 family residential properties: |                                |           |         |         |         |         |         |         |         |         |         |         |         |        
|                                                 | Revolving open-end loans & lines              |                                |           |         |         |         |         |         |         |         |         |         |         |         |        
|                                                 |                                               |                                | of credit |         | 22,868  |         |         | 23,581  |         |         | 23,295  |         |         | 18,879  |         |         | 16,569
|                                                 |                                               |                                | All other |         | 68,196  |         |         | 66,140  |         |         | 58,158  |         |         | 55,113  |         |         | 43,821
|                                                 | Secured by multifamily residential            |                                |           |         |         |         |         |         |         |         |         |         |         |         |        
|                                                 |                                               | properties                     |           | 3,913   |         |         | 4,085   |         |         | 5,088   |         |         | 3,634   |         |         | 3,265  
|                                                 | Secured by nonfarm nonresidential             |                                |           |         |         |         |         |         |         |         |         |         |         |         |        
|                                                 |                                               | properties                     |           | 102,217 |         |         | 84,189  |         |         | 72,611  |         |         | 63,372  |         |         | 42,941 
|Loans to finance agricultural production         |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |        
|                                                 | and other loans to farmers                    |                                | 2,724     |         |         | 3,729   |         |         | 4,020   |         |         | 5,084   |         |         | 6,277  
|Commercial and industrial loans                  |                                               | 37,622                         |           |         | 34,166  |         |         | 26,005  |         |         | 27,872  |         |         | 29,908 
|Loans to individuals for household,              |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |        
|                                                 | family and other personal expenditures:       |                                |           |         |         |         |         |         |         |         |         |         |         |         |        
|                                                 |                                               | Credit cards and related plans |           | 4,778   |         |         | 3,933   |         |         | 3,807   |         |         | 3,574   |         |         | 3,527  
|                                                 |                                               | Other                          |           | 11,840  |         |         | 22,438  |         |         | 13,400  |         |         | 14,458  |         |         | 17,177 
|Obligations of states and political subdivisions |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |        
|                                                 | in the U.S.:                                  |                                |           |         |         |         |         |         |         |         |         |         |         |         |         |        
|                                                 |                                               | Tax exempt obligations         |           | 199     |         |         | 113     |         |         | 225     |         |         | 332     |         |         | -      
|All other loans                                  |                                               |                                | 897       |         |         | 787     |         |         | 628     |         |         | 836     |         |         | 921    
|Lease financing receivables                      |                                               | 5                              |           |         | 9       |         |         | 12      |         |         | 13      |         |         | 14     
|Deferred cost (unearned income) on loans         |                                               | (283)                          |           |         | (318)   |         |         | (379)   |         |         | (170)   |         |         | 80     
|Total loans                                      |                                               |                                | 461,763   |         |         | 397,094 |         |         | 312,815 |         |         | 272,623 |         |         | 229,570
|Allowance for loan losses                        |                                               | (5,566)                        |           |         | (4,965) |         |         | (4,055) |         |         | (3,430) |         |         | (2,860)
|                                                 | Net loans                                     |                                | $         | 456,197 |         | $       | 392,129 |         | $       | 308,760 |         | $       | 269,193 |         | $       | 226,710
|Commitments and contingencies:                   |                                               |                                |           |         |         |         |         |         |         |         |         |         |         |        
|Commitments to make loans                        | $                                             | 140,539                        |           | $       | 97,183  |         | $       | 89,377  |         | $       | 68,731  |         | $       | 44,525 
|Standby letters of credit                        | $                                             | 4,711                          |           | $       | 4,796   |         | $       | 1,726   |         | $       | 1,003   |         | $       | 2,408  



Certain Loan Maturities



The maturities and carrying amounts of certain loans as of December 31, 2006 are summarized as follows (in thousands):



|                                  |               |               |         |              |             |         |   |         |        
|--------------------------------- | ------------- | ------------- | ------- | ------------ | ----------- | ------- | - | ------- | -------
|                                  |               |               |         |              | Real Estate |         |   |        
|                                  |               | Commercial    |         | Construction |             |         |  
|                                  |               | Financial and |         | and Land     |             |         |  
|                                  |               | Agricultural  |         | Development  |             | Total  
|Due within one year               | $             | 42,005        |         | $            | 112,563     |         | $ | 154,568
|                                  |               |               |         |              |             |         |   |         |        
|Due after one year to five years: |               |               |         |              |             |         |   |        
|                                  | Fixed rate    |               | 78,203  |              |             | 66,558  |   |         | 144,761
|                                  | Variable rate |               | 24,187  |              |             | 13,046  |   |         | 37,233 
|                                  |               |               |         |              |             |         |   |         |        
|Due after five years:             |               |               |         |              |             |         |   |        
|                                  | Fixed rate    |               | 8,061   |              |             | 2,049   |   |         | 10,110 
|                                  | Variable rate |               | 2,941   |              |             | -       |   |         | 2,941  
|Total                             |               | $             | 155,397 |              | $           | 194,216 |   | $       | 349,613







34



---





Risk Elements



Past due and nonaccrual loans, as extracted from the Call Reports of December 31, 2006, 2005, 2004, 2003 and 2002 were as follows (in thousands):



|                                             |                                |       |      |     |      |     |      |     |      |     |      |     |       |     |       |      
|-------------------------------------------- | ------------------------------ | ----- | ---- | --- | ---- | --- | ---- | --- | ---- | --- | ---- | --- | ----- | --- | ----- | -----
|                                             |                                |       | 2006 |     | 2005 |     | 2004 |     | 2003 |     | 2001
|Nonaccrual loans:                            |                                |       |      |     |      |     |      |     |      |     |      |     |       |    
|                                             | Real estate loans              | $     | 859  |     | $    | 535 |      | $   | 614  |     | $    | 739 |       | $   | 1,059
|                                             | Installment loans              |       | 58   |     |      | 114 |      |     | 80   |     |      | 96  |       |     | 191  
|                                             | Commercial and all other loans |       | 50   |     |      | 348 |      |     | 250  |     |      | 224 |       |     | 287  
|                                             |                                |       |      |     |      |     |      |     |      |     |      |     |       |     |       |      
|                                             |                                | Total | $    | 967 |      | $   | 997  |     | $    | 944 |      | $   | 1,059 |     | $     | 1,537
|                                             |                                |       |      |     |      |     |      |     |      |     |      |     |       |     |       |      
|Agricultural loans included above            | $                              | -     |      | $   | 252  |     | $    | 197 |      | $   | 110  |     | $     | 163
|                                             |                                |       |      |     |      |     |      |     |      |     |      |     |       |     |       |      
|Past due 90 days or more and still accruing: |                                |       |      |     |      |     |      |     |      |     |      |     |       |    
|                                             | Real estate loans              | $     | 33   |     | $    | 64  |      | $   | 188  |     | $    | 597 |       | $   | -    
|                                             | Installment loans              |       | -    |     |      | -   |      |     | 1    |     |      | 5   |       |     | 36   
|                                             | Credit cards and related plans |       | -    |     |      | 10  |      |     | 11   |     |      | 18  |       |     | 17   
|                                             | Commercial and all other loans |       | -    |     |      | -   |      |     | 26   |     |      | 15  |       |     | 30   
|                                             |                                |       |      |     |      |     |      |     |      |     |      |     |       |     |       |      
|                                             |                                | Total | $    | 33  |      | $   | 74   |     | $    | 226 |      | $   | 635   |     | $     | 83   
|                                             |                                |       |      |     |      |     |      |     |      |     |      |     |       |     |       |      
|Agricultural loans included above            | $                              | -     |      | $   | -    |     | $    | 26  |      | $   | -    |     | $     | 17 



The gross interest income that would have been recorded for loans accounted for on a nonaccrual basis at December 31, 2006 was approximately $91,000.  This amount represents interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination, if held for part of period.



Foreclosed assets (included in other assets) were $327,000, $247,000, $404,000, $75,000, and $442,000, at December 31, 2006, 2005, 2004, 2003, and 2002, respectively. The amount of interest recognized on impaired loans during the portion of 2006 that they were impaired was not material.



Allowance for Loan Losses and Summary of Loan Loss Experience



As a matter of policy, the bank maintains an allowance for loan losses.  The allowance for loan losses is created by direct charges to income and by recoveries of amounts previously charged off.  The allowance is reduced as losses on loans are charged against the allowance when realized.



We evaluate our loan portfolio in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loans observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses.   This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change.





35



---





The loan portfolio and the adequacy of the allowance is evaluated by management at least quarterly. In addition, our Loan Committee reviews our loan portfolio and credit quality quarterly.  The amount of the allowance is based on managements evaluation of the loan portfolio including trends in composition, growth and terms, historical and expected loan loss experience, economic conditions and conditions that may affect the borrowers ability to pay, and other factors management deems appropriate.  In addition, regulatory examiners may require the bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. The banks management believes its allowance for loan losses is adequate under existing economic conditions to absorb loan losses inherent in its loan portfolio. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio.



The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality.  If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change.





The following table summarizes the banks loan loss experience for the years ending December 31, 2006, 2005, 2004, 2003 and 2002 (in thousands, except ratios):



|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|------------------------------- | -------------------------------- | --------------------------- | ---- | ----- | ----- | --- | ----- | ----- | ---- | ----- | ----- | --- | ----- | ----- | --- | -----
|                                |                                  |                             | 2006 |       | 2005  |     | 2004  |       | 2003 |       | 2001 
|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|Balance at beginning of period  | $                                | 4,965                       |      | $     | 4,055 |     | $     | 3,430 |      | $     | 2,860 |     | $     | 2,650
|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|Charge-offs:                    |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |      
|                                | Commercial and other             |                             | 135  |       |       | 245 |       |       | 417  |       |       | 311 |       |       | 604
|                                | Real estate                      |                             | 87   |       |       | 158 |       |       | 395  |       |       | 342 |       |       | 240
|                                | Installment loans to individuals |                             | 178  |       |       | 198 |       |       | 237  |       |       | 396 |       |       | 283
|                                | Credit cards and related plans   |                             | 58   |       |       | 95  |       |       | 297  |       |       | 88  |       |       | 72 
|                                |                                  |                             |      | 458   |       |     | 696   |       |      | 1,346 |       |     | 1,137 |       |     | 1,199
|Recoveries:                     |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |      
|                                | Commercial and other             |                             | 49   |       |       | 49  |       |       | 206  |       |       | 31  |       |       | 74 
|                                | Real estate                      |                             | 32   |       |       | 19  |       |       | 27   |       |       | 134 |       |       | 13 
|                                | Installment loans                |                             | 65   |       |       | 69  |       |       | 56   |       |       | 159 |       |       | 62 
|                                | Credit cards and related plans   |                             | 40   |       |       | 66  |       |       | 86   |       |       | 10  |       |       | 12 
|                                |                                  |                             |      | 186   |       |     | 203   |       |      | 375   |       |     | 334   |       |     | 161  
|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|Net charge-offs                 |                                  | 272                         |      |       | 493   |     |       | 971   |      |       | 803   |     |       | 1,038
|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|Additions charged to operations |                                  | 873                         |      |       | 1,403 |     |       | 1,596 |      |       | 1,373 |     |       | 1,248
|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|Balance at end of year          | $                                | 5,566                       |      | $     | 4,965 |     | $     | 4,055 |      | $     | 3,430 |     | $     | 2,860
|                                |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |       |     |      
|Ratio of net charge-offs during |                                  |                             |      |       |       |     |       |       |      |       |       |     |       |      
|                                | the year to average gross loans  |                             |      |       |       |     |       |       |      |       |       |     |       |       |    
|                                |                                  | outstanding during the year |      | 0.06% |       |     | 0.14% |       |      | 0.32% |       |     | 0.32% |       |     | 0.48%





36



---





The following table summarizes the banks allocation of allowance for loan losses at December 31, 2006, 2005, 2004, 2003 and 2002 (in thousands, except ratios):



|                                |       |                 |       |           |            |        |       |           |     |            |   |           |       |     |           
|------------------------------- | ----- | --------------- | ----- | --------- | ---------- | ------ | ----- | --------- | --- | ---------- | - | --------- | ----- | --- | ----------
|                                |       | At December 31,
|                                |       | 2006            |       | 2005      |            | 2004  
|                                |       |                 |       |           | % of Total |        |       |           |     | % of Total |   |           |       |     | % of Total
|                                |       | Amount          |       | Loans (1) |            | Amount |       | Loans (1) |     | Amount     |   | Loans (1)
|Real estate loans               | $     | 4,866           |       | 87%       |            | $      | 4,150 |           | 84% |            | $ | 3,432     |       | 84%
|Commercial and industrial loans |       | 486             |       | 9%        |            |        | 474   |           | 10% |            |   | 389       |       | 10%
|Installment loans               |       | 200             |       | 4%        |            |        | 330   |           | 6%  |            |   | 223       |       | 6% 
|Unallocated                     |       | 14              |       | -%        |            |        | 11    |           | -%  |            |   | 11        |       | -% 
|                                | Total | $               | 5,566 |           | 100%       |        | $     | 4,965     |     | 100%       |   | $         | 4,055 |     | 100%      





|                                |       |                 |       |           |            |        |       |           |     |           
|------------------------------- | ----- | --------------- | ----- | --------- | ---------- | ------ | ----- | --------- | --- | ----------
|                                |       | At December 31,
|                                |       | 2003            |       | 2002     
|                                |       |                 |       |           | % of Total |        |       |           |     | % of Total
|                                |       | Amount          |       | Loans (1) |            | Amount |       | Loans (1)
|Real estate loans               | $     | 2,773           |       | 81%       |            | $      | 2,139 |           | 75%
|Commercial and industrial loans |       | 415             |       | 12%       |            |        | 451   |           | 16%
|Installment loans               |       | 227             |       | 7%        |            |        | 258   |           | 9% 
|Unallocated                     |       | 15              |       | -%        |            |        | 12    |           | -% 
|                                | Total | $               | 3,430 |           | 100%       |        | $     | 2,860     |     | 100%      





________________________

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



Deposits

Time certificates in amounts of $100,000 or more outstanding at December 31, 2006 by maturity were as follows (in thousands):



|                                       |   |        
|-------------------------------------- | - | -------
|Three months or less                   | $ | 37,658 
|Over three months through six months   |   | 38,068 
|Over six months through twelve months  |   | 42,716 
|Over twelve months through three years |   | 45,277 
|Over three years                       |   | 778    
|                                       |   |        
|Total                                  | $ | 164,497



Borrowings



The bank borrows funds principally from the FHLB.  Information regarding such borrowings is as follows (in thousands, except rates):



|                                        |      |        |      |   |        |  |   |       
|--------------------------------------- | ---- | ------ | ---- | - | ------ |  | - | ------
|                                        | 2006 |        | 2005 |   | 2004  
|                                        |      |        |      |   |        |  |   |       
|Balance outstanding at December 31      | $    | 70,000 |      | $ | 63,000 |  | $ | 43,000
|Weighted average rate at December 31    |      | 4.65%  |      |   | 4.44%  |  |   | 3.86% 
|Maximum borrowings during the year      | $    | 70,000 |      | $ | 63,000 |  | $ | 43,000
|Average amounts outstanding during year | $    | 62,103 |      | $ | 48,945 |  | $ | 42,799
|Weighted average rate during year       |      | 4.65%  |      |   | 4.23%  |  |   | 3.94% 



37



---







| |  |  |  |  |  |  |  | 
| |  |  |  |  |  |  |  | 

There were no short-term advances outstanding from the FHLB at December 31, 2006. For 2006 and 2005, average outstanding short-term balances were $1,221,000 and $148,000, respectively.  At December 31, 2005, there were short-term advances of $480,000 FHLB advances outstanding.



In addition, the bank may purchase federal funds through unsecured federal funds lines of credit with various banks aggregating $32.7 million.  These lines are intended for short-term borrowings and are payable on demand and bear interest based upon the daily federal funds rate.  For 2006 and 2005, average federal funds purchased were $1.8 million and $1.9 million, respectively. At December 31, 2006 the bank had $3.4 million of federal funds borrowings outstanding under these lines. At December 31, 2005, there were $10.5 million federal funds borrowings outstanding.



The bank completed a $12 million offering of Trust Preferred Securities on March 30, 2006.  Net proceeds from the sale of the Trust Preferred Securities were invested in Junior Subordinated Deferrable Interest Debentures issued by the Company.





Critical Accounting Estimates and Policies



We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.



Critical accounting estimates and policies are those we believe are both most important to the portrayal of our financial condition and results, and require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions. We believe that the allowance for loan losses represents a particularly sensitive accounting estimate.  The amount of the allowance is based on managements evaluation of the collectibility of the loan portfolio, including the maturity of the loan portfolio, credit concentration, trends in historical loss experience, specific impaired loans and general economic conditions.  See Note A to the consolidated financial statements for a comprehensive discussion of our accounting policy for the allowance for loan losses.



New Accounting Standards



In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48"), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in enterprises' financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006.  The Company adopted FIN 48 on January 1, 2007 and is currently analyzing the effects of the interpretation on its consolidated financial statements.



In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements.  (SFAS No. 157) defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but rather eliminates inconsistencies found in various prior pronouncements. SFAS No. 157 is effective for the Company on January 1, 2008 and is not expected to have a significant impact on the Company's consolidated financial statements.





38



---





In September 2006, the FASB issued SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, (SFAS No. 158) which amends SFAS No. 87 and SFASNo. 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS No. 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS No. 87 and SFAS No. 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects, until they are amortized as a component of net periodic cost. The measurement date  the date at which the benefit obligation and plan assets are measured  is required to be the company's fiscal year end. SFAS No. 158 is effective for publicly-held companies for fiscal years ending after December 15, 2006, except for the measurement date provisions, which are effective for fiscal years ending after December 15, 2008.  The Companys adoption of SFAS No. 158 as of December 31, 2006 had no effect on its consolidated financial statements.



In September, 2006, the FASB ratified the consensuses reached by the FASB's Emerging Issues Task Force relating to EITF 06-4 Accounting for the Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. (EITF 06-4). EITF 06-4 states that an employer accounting for endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods should recognize a liability for future benefits in accordance with SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, or APB Opinion No. 12, Omnibus Opinion1967. EITF 06-4 is effective for fiscal years beginning after December 15, 2007.  Entities should recognize the effects of applying this issue through either (a) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption or (b) a change in accounting principle through retrospective application to all prior periods. The Company is currently analyzing the effect of the adoption of EITF 06-4 on its consolidated financial statements.



In September 2006, the SEC issued Staff Accounting Bulletin (SAB 108).  SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a potential current year misstatement. Prior to SAB 108, companies might evaluate the materiality of financial statement misstatements using either the income statement or balance sheet approach, with the income statement approach focusing on new misstatements added in the current year, and the balance sheet approach focusing on the cumulative amount of misstatement present in a company's balance sheet. Misstatements that would be material under one approach could be viewed as immaterial under another approach and not be corrected. SAB 108 now requires that companies view financial statement misstatements as material if they are material according to either the income statement or balance sheet approach. The Company adopted SAB 108 effective for the year ended December 31, 2006 with no impact on the reported results of operations or financial conditions.



Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Companys financial position, results of operations and cash flows.





Item 7A  Quantitative and Qualitative Disclosures About Market Risk.



This information is included under Item 7 of this report under the captions Interest Rate Sensitivity, Market Risk, and Derivative Financial Instruments.



Item 8 - Financial Statements and Supplementary Data.



39



---





[f2006fouroaks10k004.gif]





REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM







The Board of Directors and Shareholders

Four Oaks Fincorp,Inc.

Four Oaks, North Carolina





We have audited the accompanying consolidated balance sheets of Four Oaks Fincorp, Inc. and Subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of operations, comprehensive income, shareholders equity and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.



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



We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness Four Oaks, Fincorp, Inc.s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 14, 2007 expressed unqualified opinions on both managements assessment of the Companys internal control over financial reporting and the effectiveness of the Companys internal control over financial reporting.





/s/ Dixon Hughes PLLC

Dixon Hughes

Sanford, North Carolina

March 14, 2007



40



---





Four Oaks Fincorp, Inc.

Consolidated Balance Sheets

December 31, 2006 and 2005



|                                                                                                                                                               |                                          |         |      |   |        
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------- | ------- | ---- | - | -------
|                                                                                                                                                               | 2006                                     |         | 2005
|                                                                                                                                                               | (Amounts in thousands except share data)
|ASSETS                                                                                                                                                         |                                          |         |      |   |        
|Cash and due from banks                                                                                                                                        | $                                        | 13,960  |      | $ | 13,211 
|Interest-earning deposits                                                                                                                                      |                                          | 3,751   |      |   | 9,704  
|Investment securities available for sale, at fair value                                                                                                        |                                          | 101,393 |      |   | 80,209 
|                                                                                                                                                               |                                          |         |      |   |        
|Loans                                                                                                                                                          |                                          | 461,763 |      |   | 397,094
|Allowance for loan losses                                                                                                                                      |                                          | (5,566) |      |   | (4,965)
|Net loans                                                                                                                                                      |                                          | 456,197 |      |   | 392,129
|                                                                                                                                                               |                                          |         |      |   |        
|Accrued interest receivable                                                                                                                                    |                                          | 3,614   |      |   | 2,950  
|Bank premises and equipment, net                                                                                                                               |                                          | 11,630  |      |   | 9,683  
|FHLB stock                                                                                                                                                     |                                          | 4,194   |      |   | 3,655  
|Investment in life insurance                                                                                                                                   |                                          | 8,424   |      |   | 7,875  
|Other assets                                                                                                                                                   |                                          | 4,974   |      |   | 3,456  
|                                                                                                                                                               |                                          |         |      |   |        
|Total assets                                                                                                                                                   | $                                        | 608,137 |      | $ | 522,872
|                                                                                                                                                               |                                          |         |      |   |        
|LIABILITIES AND SHAREHOLDERS' EQUITY                                                                                                                           |                                          |         |      |   |        
|                                                                                                                                                               |                                          |         |      |   |        
|Deposits:                                                                                                                                                      |                                          |         |      |   |        
|Non-interest-bearing demand                                                                                                                                    | $                                        | 72,087  |      | $ | 68,993 
|Money market and NOW accounts                                                                                                                                  |                                          | 89,615  |      |   | 59,251 
|Savings                                                                                                                                                        |                                          | 31,424  |      |   | 43,900 
|Time deposits, $100,000 and over                                                                                                                               |                                          | 164,497 |      |   | 141,997
|Other time deposits                                                                                                                                            |                                          | 109,245 |      |   | 84,200 
|Total deposits                                                                                                                                                 |                                          | 466,868 |      |   | 398,341
|                                                                                                                                                               |                                          |         |      |   |        
|Borrowings                                                                                                                                                     |                                          | 73,400  |      |   | 74,140 
|Subordinated debentures                                                                                                                                        |                                          | 12,372  |      |   | -      
|Accrued interest payable                                                                                                                                       |                                          | 3,258   |      |   | 2,255  
|Other liabilities                                                                                                                                              |                                          | 2,916   |      |   | 6,524  
|Total liabilities                                                                                                                                              |                                          | 558,814 |      |   | 481,260
|                                                                                                                                                               |                                          |         |      |   |        
|Commitments and Contingencies (Notes D, J, K and N )                                                                                                           |                                          |         |      |   |        
|                                                                                                                                                               |                                          |         |      |   |        
|Shareholders equity:                                                                                                                                          |                                          |         |      |   |        
|Common stock; $1.00 par value, 10,000,000 shares authorized; 5,577,862 and 4,379,258 shares issued and outstanding at December 31, 2006 and 2005, respectively |                                          | 5,578   |      |   | 4,379  
|Additional paid-in capital                                                                                                                                     |                                          | 10,016  |      |   | 9,178  
|Retained earnings                                                                                                                                              |                                          | 34,141  |      |   | 28,815 
|Accumulated other comprehensive loss                                                                                                                           |                                          | (412)   |      |   | (760)  
|Total shareholders equity                                                                                                                                     |                                          | 49,323  |      |   | 41,612 
|                                                                                                                                                               |                                          |         |      |   |        
|Total liabilities and shareholders equity                                                                                                                     | $                                        | 608,137 |      | $ | 522,872





The accompanying notes are an integral part of these consolidated financial statements.

41





---







Four Oaks Fincorp, Inc.

Consolidated Statements of Operations

For the Years Ended December 31, 2006, 2005 and 2004



|                                                    |                                               |        |       |   |        |  |   |       
|--------------------------------------------------- | --------------------------------------------- | ------ | ----- | - | ------ |  | - | ------
|                                                    | 2006                                          |        | 2,005 |   | 2004  
|                                                    | (Amounts in thousands, except per share data)
|Interest and dividend income:                       |                                               |        |       |   |        |  |   |       
|Loans, including fees                               | $                                             | 35,457 |       | $ | 26,612 |  | $ | 19,968
|Investment securities:                              |                                               |        |       |   |        |  |   |       
|Taxable                                             |                                               | 4,503  |       |   | 2,389  |  |   | 1,470 
|Tax-exempt                                          |                                               | 152    |       |   | 118    |  |   | 162   
|Dividends                                           |                                               | 287    |       |   | 155    |  |   | 109   
|Interest-earning deposits                           |                                               | 157    |       |   | 130    |  |   | 39    
|Total interest and dividend income                  |                                               | 40,556 |       |   | 29,404 |  |   | 21,748
|                                                    |                                               |        |       |   |        |  |   |       
|Interest expense:                                   |                                               |        |       |   |        |  |   |       
|Deposits                                            |                                               | 14,202 |       |   | 7,823  |  |   | 4,123 
|Borrowings                                          |                                               | 3,615  |       |   | 2,160  |  |   | 1,688 
|Total interest expense                              |                                               | 17,817 |       |   | 9,983  |  |   | 5,811 
|                                                    |                                               |        |       |   |        |  |   |       
|Net interest income                                 |                                               | 22,739 |       |   | 19,421 |  |   | 15,937
|                                                    |                                               |        |       |   |        |  |   |       
|Provision for loan losses                           |                                               | 873    |       |   | 1,403  |  |   | 1,596 
|Net interest income after provision for loan losses |                                               | 21,866 |       |   | 18,018 |  |   | 14,341
|                                                    |                                               |        |       |   |        |  |   |       
|Non-interest income:                                |                                               |        |       |   |        |  |   |       
|Service charges on deposit accounts                 |                                               | 2,053  |       |   | 1,875  |  |   | 1,941 
|Other service charges, commissions and fees         |                                               | 1,551  |       |   | 1,235  |  |   | 1,024 
|Gains (losses) on sale of investment securities     |                                               | (121)  |       |   | (386)  |  |   | 71    
|Gains (losses) on hedges, net                       |                                               | (262)  |       |   | (397)  |  |   | -     
|Gains on sale of loans                              |                                               | 103    |       |   | 61     |  |   | 72    
|Merchant fees                                       |                                               | 402    |       |   | 389    |  |   | 347   
|Income from investment in bank-owned life insurance |                                               | 549    |       |   | 300    |  |   | 394   
|Total non-interest income                           |                                               | 4,275  |       |   | 3,077  |  |   | 3,849 
|                                                    |                                               |        |       |   |        |  |   |       
|Non-interest expenses:                              |                                               |        |       |   |        |  |   |       
|Salaries                                            |                                               | 7,163  |       |   | 6,033  |  |   | 5,354 
|Employee benefits                                   |                                               | 1,477  |       |   | 1,306  |  |   | 1,037 
|Occupancy expenses                                  |                                               | 681    |       |   | 549    |  |   | 508   
|Equipment expenses                                  |                                               | 1,438  |       |   | 1,313  |  |   | 1,223 
|Professional and consulting fees                    |                                               | 1,183  |       |   | 965    |  |   | 747   
|Other taxes and licenses                            |                                               | 271    |       |   | 248    |  |   | 251   
|Merchant processing expenses                        |                                               | 355    |       |   | 341    |  |   | 304   
|Other operating expenses                            |                                               | 2,929  |       |   | 2,599  |  |   | 2,083 
|Total non-interest expenses                         |                                               | 15,497 |       |   | 13,354 |  |   | 11,507
|                                                    |                                               |        |       |   |        |  |   |       
|Income before income taxes                          |                                               | 10,644 |       |   | 7,741  |  |   | 6,683 
|Provision for income taxes                          |                                               | 3,627  |       |   | 2,738  |  |   | 2,308 
|                                                    |                                               |        |       |   |        |  |   |       
|Net income                                          | $                                             | 7,017  |       | $ | 5,003  |  | $ | 4,375 
|                                                    |                                               |        |       |   |        |  |   |       
|Basic net income per common share                   | $                                             | 1.27   |       | $ | 0.92   |  | $ | 0.82  
|                                                    |                                               |        |       |   |        |  |   |       
|Diluted net income per common share                 | $                                             | 1.26   |       | $ | 0.91   |  | $ | 0.82  





The accompanying notes are an integral part of these consolidated financial statements.

42





---







Four Oaks Fincorp, Inc.

Consolidated Statements of Comprehensive Income

For the Years Ended December 31, 2006, 2005 and 2004



|                                                                   |                        |       |      |   |         |  |   |      
|------------------------------------------------------------------ | ---------------------- | ----- | ---- | - | ------- |  | - | -----
|                                                                   | 2006                   |       | 2005 |   | 2004   
|                                                                   | (Amounts in thousands)
|                                                                   |                        |       |      |   |         |  |   |      
|Net income                                                         | $                      | 7,017 |      | $ | 5,003   |  | $ | 4,375
|                                                                   |                        |       |      |   |         |  |   |      
|Other comprehensive income (loss):                                 |                        |       |      |   |         |  |   |      
|Securities available for sale:                                     |                        |       |      |   |         |  |   |      
|Unrealized holding gains (losses) on available for
sale securities |                        | 145   |      |   | (1,326) |  |   | (109)
|Tax effect                                                         |                        | (57)  |      |   | 529     |  |   | 44   
|Reclassification of (gains) losses recognized in net
income        |                        | 121   |      |   | 386     |  |   | (71) 
|Tax effect                                                         |                        | (48)  |      |   | (154)   |  |   | 28   
|Net of tax amount                                                  |                        | 161   |      |   | (565)   |  |   | (108)
|                                                                   |                        |       |      |   |         |  |   |      
|Cash flow hedging activities:                                      |                        |       |      |   |         |  |   |      
|Unrealized holding gains (losses) on cash flow
hedging activities  |                        | 314   |      |   | (290)   |  |   | (370)
|Tax effect                                                         |                        | (127) |      |   | 117     |  |   | 148  
|Net of tax amount                                                  |                        | 187   |      |   | (173)   |  |   | (222)
|                                                                   |                        |       |      |   |         |  |   |      
|Total other comprehensive income (loss):                           |                        | 348   |      |   | (738)   |  |   | (330)
|                                                                   |                        |       |      |   |         |  |   |      
|Comprehensive income                                               | $                      | 7,365 |      | $ | 4,265   |  | $ | 4,045







The accompanying notes are an integral part of these consolidated financial statements.

43





---





Four Oaks Fincorp, Inc.

Consolidated Statements of Shareholders Equity

For the Years Ended December 31, 2006, 2005 and 2004



|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|-------------------------- | -------------------------------- | ----------------------------------------- | - | ------ | ----- | ------- | ---------- | -------- | -------- | -------------- | ------------- | ------ | ------------- | ----- | - | ------ | -------
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        | Accumulated   |       |   |       
|                           |                                  |                                           |   |        |       |         | Additional |          |          |                |               | other  |               | Total
|                           |                                  | Common stock                              |   |        |       |         | paid-in    |          | Retained |                | comprehensive |        | shareholders
|                           |                                  | Shares                                    |   | Amount |       | capital |            | earnings |          | income  (loss) |               | equity
|                           |                                  | (Amounts in thousands, except share data)
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|BALANCE, DECEMBER 31, 2003 | 2,676,263                        |                                           | $ | 2,676  |       | $       | 8,029      |          | $        | 21,867         |               | $      | 308           |       | $ | 32,880
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Net income                       | -                                         |   |        | -     |         |            | -        |          |                | 4,375         |        |               | -     |   |        | 4,375  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Other comprehensive loss         | -                                         |   |        | -     |         |            | -        |          |                | -             |        |               | (330) |   |        | (330)  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Effect of 5-for-4 stock split    | 682,474                                   |   |        | 683   |         |            | (683)    |          |                | -             |        |               | -     |   |        | -      
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Issuance of common stock         | 82,170                                    |   |        | 82    |         |            | 1,348    |          |                | -             |        |               | -     |   |        | 1,430  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Current income tax benefit       | -                                         |   |        | -     |         |            | 94       |          |                | -             |        |               | -     |   |        | 94     
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Purchases and retirement         |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | of common stock                  | (2,800)                                   |   |        | (3)   |         |            | -        |          |                | (62)          |        |               | -     |   |        | (65)   
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Cash dividends of $.26 per share | -                                         |   |        |       |         |            | -        |          |                | (1,089)       |        |               | -     |   |        | (1,089)
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|BALANCE, DECEMBER 31, 2004 | 3,438,107                        |                                           |   | 3,438  |       |         | 8,788      |          |          | 25,091         |               |        | (22)          |       |   | 37,295
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Net income                       | -                                         |   |        | -     |         |            | -        |          |                | 5,003         |        |               | -     |   |        | 5,003  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Other comprehensive loss         | -                                         |   |        | -     |         |            | -        |          |                | -             |        |               | (738) |   |        | (738)  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Effect of 5-for-4 stock split    | 872,060                                   |   |        | 872   |         |            | (872)    |          |                | -             |        |               | -     |   |        | -      
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Issuance of common stock         | 69,091                                    |   |        | 69    |         |            | 1,161    |          |                | -             |        |               | -     |   |        | 1,230  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Current income tax benefit       | -                                         |   |        | -     |         |            | 101      |          |                | -             |        |               | -     |   |        | 101    
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Cash dividends of $.30 per share | -                                         |   |        | -     |         |            | -        |          |                | (1,279)       |        |               | -     |   |        | (1,279)
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|BALANCE, DECEMBER 31, 2005 | 4,379,258                        |                                           |   | 4,379  |       |         | 9,178      |          |          | 28,815         |               |        | (760)         |       |   | 41,612
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Net income                       | -                                         |   |        | -     |         |            | -        |          |                | 7,017         |        |               | -     |   |        | 7,017  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Other comprehensive income       | -                                         |   |        | -     |         |            | -        |          |                | -             |        |               | 348   |   |        | 348    
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Effect of 5-for-4 stock split    | 1,109,543                                 |   |        | 1,110 |         |            | (1,110)  |          |                | -             |        |               | -     |   |        | -      
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Issuance of common stock         | 98,896                                    |   |        | 98    |         |            | 1,511    |          |                | -             |        |               | -     |   |        | 1,609  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Current income tax benefit       | -                                         |   |        | -     |         |            | 293      |          |                | -             |        |               |       |   |        | 293    
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Stock based compensation         | -                                         |   |        | -     |         |            | 144      |          |                | -             |        |               | -     |   |        | 144    
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Purchases and retirement         |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | of common stock                  | (9,835)                                   |   |        | (9)   |         |            | -        |          |                | (243)         |        |               | -     |   |        | (252)  
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|                           | Cash dividends of $.30 per share | -                                         |   |        | -     |         |            | -        |          |                | (1,448)       |        |               | -     |   |        | (1,448)
|                           |                                  |                                           |   |        |       |         |            |          |          |                |               |        |               |       |   |        |        
|BALANCE, DECEMBER 31, 2006 | 5,577,862                        |                                           | $ | 5,578  |       | $       | 10,016     |          | $        | 34,141         |               | $      | (412)         |       | $ | 49,323





The accompanying notes are an integral part of these consolidated financial statements.

44





---





Four Oaks Fincorp, Inc.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2006, 2005 and 2004





|                                                                        |                        |          |      |   |           |  |   |         
|----------------------------------------------------------------------- | ---------------------- | -------- | ---- | - | --------- |  | - | --------
|                                                                        | 2006                   |          | 2005 |   | 2004     
|                                                                        | (Amounts in thousands)
|Cash flows from operating activities:                                   |                        |          |      |   |           |  |   |         
|Net income                                                              | $                      | 7,017    |      | $ | 5,003     |  | $ | 4,375   
|Adjustments to reconcile net income to net cash provided by operations: |                        |          |      |   |           |  |   |         
|Provision for loan losses                                               |                        | 873      |      |   | 1,403     |  |   | 1,596   
|Provision for depreciation and amortization                             |                        | 1,022    |      |   | 1,038     |  |   | 1,008   
|Deferred income tax benefit                                             |                        | (319)    |      |   | (672)     |  |   | (188)   
|Net amortization of bond premiums and discounts                         |                        | (28)     |      |   | 18        |  |   | 109     
|Stock based compensation                                                |                        | 144      |      |   | -         |  |   | -       
|Gain on sale of loans                                                   |                        | (103)    |      |   | (61)      |  |   | (72)    
|(Gain) loss on sale of investment securities                            |                        | 121      |      |   | 386       |  |   | (71)    
|(Gain) loss on sale of foreclosed assets                                |                        | (2)      |      |   | -         |  |   | 25      
|Loss on disposition of premises and equipment                           |                        | 73       |      |   | -         |  |   | 7       
|Increase in cash surrender value of life insurance                      |                        | (549)    |      |   | (300)     |  |   | (394)   
|Net change in hedge activity                                            |                        | (262)    |      |   | (397)     |  |   | -       
|Changes in assets and liabilities:                                      |                        |          |      |   |           |  |   |         
|Other assets                                                            |                        | (1,365)  |      |   | 50        |  |   | 545     
|Interest receivable                                                     |                        | (664)    |      |   | (740)     |  |   | (317)   
|Other liabilities                                                       |                        | (3,032)  |      |   | 4,797     |  |   | 52      
|Interest payable                                                        |                        | 1,003    |      |   | 1,054     |  |   | (83)    
|Net cash provided by operating activities                               |                        | 3,929    |      |   | 11,579    |  |   | 6,592   
|                                                                        |                        |          |      |   |           |  |   |         
|Cash flows from investing activities:                                   |                        |          |      |   |           |  |   |         
|Proceeds from sales and calls of investment                             |                        |          |      |   |           |  |   |         
|securities available for sale                                           |                        | 36,759   |      |   | 36,783    |  |   | 41,422  
|Proceeds from maturities of investment                                  |                        |          |      |   |           |  |   |         
|securities available for sale                                           |                        | 275      |      |   |           |  | - |         
|Purchase of investment securities available for sale                    |                        | (58,045) |      |   | (65,994)  |  |   | (55,779)
|Purchase of FHLB stock                                                  |                        | (1,825)  |      |   | (1,034)   |  |   | (698)   
|Redemption of FHLB stock                                                |                        | 1,286    |      |   | -         |  |   | -       
|Net increase in loans                                                   |                        | (65,107) |      |   | (85,142)  |  |   | (42,305)
|Purchases of bank premises and equipment                                |                        | (3,028)  |      |   | (558)     |  |   | (568)   
|Purchases of bank-owned life insurance                                  |                        | -        |      |   | (1,521)   |  |   | (3,552) 
|Proceeds from sale of foreclosed assets                                 |                        | 193      |      |   | 589       |  |   | 860     
|Expenditures on foreclosed assets                                       |                        | (1)      |      |   | (1)       |  |   | -       
|Net cash used by investing activities                                   |                        | (89,493) |      |   | (116,878) |  |   | (60,620)
|Cash flows from financing activities:                                   |                        |          |      |   |           |  |   |         
|Net proceeds from borrowings                                            |                        | (740)    |      |   | 30,980    |  |   | 10,000  
|Net increase in deposit accounts                                        |                        | 68,526   |      |   | 83,034    |  |   | 42,176  
|Proceeds from subordinated debentures                                   |                        | 12,372   |      |   | -         |  |   | -       
|Proceeds from issuance of common stock                                  |                        | 1,609    |      |   | 1,230     |  |   | 1,430   
|Excess tax benefits from stock options                                  |                        | 293      |      |   | -         |  |   | -       
|Purchases and retirement of common stock                                |                        | (252)    |      |   | -         |  |   | (65)    
|Cash dividends paid                                                     |                        | (1,448)  |      |   | (1,279)   |  |   | (1,089) 
|Net cash provided by financing activities                               |                        | 80,360   |      |   | 113,965   |  |   | 52,452  
|                                                                        |                        |          |      |   |           |  |   |         
|Net increase (decrease) in cash and cash equivalents                    |                        | (5,204)  |      |   | 8,666     |  |   | (1,576) 
|                                                                        |                        |          |      |   |           |  |   |         
|Cash and cash equivalents at beginning of year                          |                        | 22,915   |      |   | 14,249    |  |   | 15,825  
|Cash and cash equivalents at end of year                                | $                      | 17,711   |      | $ | 22,915    |  | $ | 14,249  



The accompanying notes are an integral part of these consolidated financial statements.

45





---







NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Basis of Presentation



The consolidated financial statements include the accounts and transactions of Four Oaks Fincorp, Inc. (the Company), a bank holding company incorporated under the laws of the State of North Carolina, and its wholly owned subsidiaries, Four Oaks Bank & Trust Company, Inc. (the Bank) and Four Oaks Mortgage Services, LLC, the Companys mortgage origination subsidiary. All significant intercompany transactions have been eliminated. In March 2006, the Company formed Four Oaks Statutory Trust I, a wholly owned Delaware statutory business trust (the Trust), for the sole purpose of issuing Trust Preferred Securities (as defined in Note G below).  The Trust is not included in the consolidated financial statements of the Company, in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities (revised December 2003)  an interpretation of ARB No. 51 (FIN 46R).



Nature of Operations



The Company was incorporated under the laws of the State of North Carolina on February 5, 1997. The Companys primary function is to serve as the holding company for its wholly owned subsidiaries, the Bank and Four Oaks Mortgage Services, LLC. The Bank operates thirteen offices in eastern and central North Carolina, and its primary source of revenue is derived from loans to customers and from its securities portfolio. The loan portfolio is comprised mainly of real estate, commercial and consumer loans. These loans are primarily collateralized by residential and commercial properties, commercial equipment, and personal property.



SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Use of Estimates



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



Cash and Cash Equivalents



For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet captions cash and due from banks and interest-earning deposits.



Federal regulations require institutions to set aside specified amounts of cash as reserves against transactions and time deposits.  As of December 31, 2006, the daily average gross reserve requirement was $3.0 million.



Investment Securities



Investment securities are classified into three categories:



(1) Held to Maturity - Debt securities that the Company has the positive intent and the ability to hold to maturity are classified as held to maturity and reported at amortized cost;



(2) Trading - Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and



The accompanying notes are an integral part of these consolidated financial statements.

46





---





NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)





(3) Available for Sale - Debt and equity securities not classified as either securities held to maturity or trading securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of income taxes, as other comprehensive income, a separate component of shareholders' equity.



The Company has historically classified all securities as available for sale. Gains and losses on sales of securities, computed based on specific identification of adjusted cost of each security, are included in income at the time of the sale. Premiums and discounts are amortized into interest income using a method that approximates the interest method over the period to maturity.



Loans and Allowance for Loan Losses



Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding.



Loan origination fees are deferred, as well as certain direct loan origination costs. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans utilizing the interest method.



The Company evaluates its loan portfolio in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure. Under these standards, a loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate or the loans observable market price, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses.



The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. In addition to the review of loans considered impaired as discussed above, the allowance for loan losses is also based upon such factors as changes in the trends in volumes and terms of loans, levels and trends of charge-offs and recoveries, national and local economic trends and conditions that may affect the borrowers ability to pay, effects of changes in risk selection and underwriting standards as well as overall portfolio quality.  If conditions change substantially from the assumptions used to evaluate the allowance for loan losses, it is possible that management's assessment of the allowance may change. In addition, regulatory examiners may require the Bank to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination.



Income Recognition on Impaired and Nonaccrual Loans



Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.



Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms.







The accompanying notes are an integral part of these consolidated financial statements.

47





---







NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)



While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.



Foreclosed Assets



Assets acquired as a result of foreclosure are valued at fair value at the date of foreclosure establishing a new cost basis.  After foreclosure, valuations of the property are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell.  Losses from the acquisition of property in full or partial satisfaction of debt are treated as credit losses. Routine holding costs, subsequent declines in value, and gains or losses on disposition are included in other income and expense.



Bank Premises and Equipment



Land is carried at cost. Buildings, furniture and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on the estimated useful lives of assets. Useful lives range from 5 to 10 years for furniture and equipment and 40 years for buildings. Expenditures for repairs and maintenance are charged to expense as incurred.



Income Taxes



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



Stock in Federal Home Loan Bank of Atlanta



As a requirement for membership, the Company invests in stock of the FHLB of Atlanta. This investment is carried at cost.  Due to the redemptive provisions of the FHLB, the Company estimated that fair value equals cost and that this investment was not impaired as of December 31, 2006.



Comprehensive Income



Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income.  Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards.  Components of other comprehensive income for the Company consist of the unrealized gains and losses, net of taxes, in the Companys available for sale securities portfolio and unrealized gains and losses, net of taxes, in the Companys cash flow hedge instruments.





The accompanying notes are an integral part of these consolidated financial statements.

48





---





NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)



Accumulated other comprehensive income at December 31, 2006 and 2005 consists of the following:





|                                                                                 |                        |       |      |   |      
|-------------------------------------------------------------------------------- | ---------------------- | ----- | ---- | - | -----
|                                                                                 | 2006                   |       | 2005
|                                                                                 | (Amounts in thousands)
|Unrealized holding gains (losses) - investment securities available for sale     | $                      | (283) |      | $ | (550)
|Deferred income taxes                                                            |                        | 113   |      |   | 219  
|Net unrealized holding gains (losses) - investment securities available for sale |                        | (170) |      |   | (331)
|                                                                                 |                        |       |      |   |      
|Unrealized holding losses - cash flow hedge instruments                          |                        | (402) |      |   | (716)
|Deferred income taxes                                                            |                        | 160   |      |   | 287  
|Net unrealized holding losses - cash flow hedge instruments                      |                        | (242) |      |   | (429)
|                                                                                 |                        |       |      |   |      
|Total accumulated other comprehensive loss                                       | $                      | (412) |      | $ | (760)



Stock Compensation Plans



Prior to 2006, SFAS No. 123, Accounting for Stock-Based Compensation, encouraged all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost was measured at the grant date based on the value of the award and was recognized over the service period, which was usually the vesting period. However, it also allowed an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (APB Opinion No. 25) whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock.



In December 2004, the FASB issued SFAS No. 123(R),

Share-Based Payment

 (SFAS No. 123(R)), which was a revision of SFAS No. 123 and superseded APB Opinion No. 25.  Under SFAS No. 123, stock

 options issued under the Companys stock option plans

had

 no intrinsic value at the grant date and, under APB Opinion No. 25, no compensation cost

was recognized for them. SFAS No. 123(R) required companies to begin recognizing in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees over the period during which an employee is required to provide service in exchange for the award, which is often the shorter of the vesting period of the period the employee will be retirement eligible. SFAS No. 123(R) also sets accounting requirements for share-based compensation to employees, including employee-stock purchase plans (ESPPs). Awards to most non-employee directors will be accounted for as employee awards

.. The Company adopted SFAS No 123(R) commencing

January 1,

 2006, using the modified porspective application as permitted under SFAS No. 123(R). Accordingly, prior period amounts have not been restated.  Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Pro forma disclosures of net income and earnings per share and other disclosures as if the fair value based method of accounting had been applied for 2005 and 2004 are provided below.



The accompanying notes are an integral part of these consolidated financial statements.

49





---











NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)



|                                                                                                                                       |                                               |       |      |   |      
|-------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------- | ----- | ---- | - | -----
|                                                                                                                                       | 2005                                          |       | 2004
|                                                                                                                                       | (Amounts in thousands,
except per share data)
|                                                                                                                                       |                                               |       |      |   |      
|Net income:                                                                                                                            |                                               |       |      |   |      
|As reported                                                                                                                            | $                                             | 5,003 |      | $ | 4,375
|Deduct:  Total stock-based employee compensation expense
determined under fair value method for all awards, net of related tax effects |                                               | (88)  |      |   | (64) 
|                                                                                                                                       |                                               |       |      |   |      
|Pro forma                                                                                                                              | $                                             | 4,915 |      | $ | 4,311
|                                                                                                                                       |                                               |       |      |   |      
|Basic earnings per share:                                                                                                              |                                               |       |      |   |      
|As reported                                                                                                                            | $                                             | 0.92  |      | $ | 0.82 
|Pro forma                                                                                                                              |                                               | 0.91  |      |   | 0.81 
|                                                                                                                                       |                                               |       |      |   |      
|Diluted earnings per share:                                                                                                            |                                               |       |      |   |      
|As reported                                                                                                                            | $                                             | 0.91  |      | $ | 0.82 
|Pro forma                                                                                                                              |                                               | 0.90  |      |   | 0.81 



Net Income Per Common Share and Common Shares Outstanding



Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. The weighted average number of shares outstanding during each period have been retroactively adjusted for five for four stock splits distributed in the form of 25% stock dividend on November 10, 2006, November 25, 2005, and October 29, 2004.  Potential common shares that may be issued by the Company relate solely to outstanding stock options.



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



|                                                   |           |  |           |  |          
|-------------------------------------------------- | --------- |  | --------- |  | ---------
|                                                   | 2006      |  | 2005      |  | 2004     
|                                                   |           |  |           |  |          
|Weighted average number of common shares used      |           |  |           |  |          
|in computing basic net income per common share     | 5,527,980 |  | 5,429,157 |  | 5,308,351
|                                                   |           |  |           |  |          
|Effect of dilutive stock options                   | 51,313    |  | 40,224    |  | 30,211   
|                                                   |           |  |           |  |          
|Weighted average number of common shares and       |           |  |           |  |          
|dilutive potential common shares used in computing |           |  |           |  |          
|diluted net income per common share                | 5,579,293 |  | 5,469,381 |  | 5,338,562



There were no antidilutive shares outstanding for the years ended December 31, 2006, 2005 and 2004.



The accompanying notes are an integral part of these consolidated financial statements.

50





---





NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)



Derivative Instruments



The Company utilizes interest rate swaps in the management of interest rate risk.  Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments.  A swap allows both parties to alter the repricing characteristics of assets or liabilities without affecting the underlying principal positions.  Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another.  Swap terms generally range from one year to ten years depending on the need.



The net interest payable or receivable on interest rate swaps that are designated as hedges is accrued and recognized as an adjustment to the interest income or expense of the related asset or liability.  Gains and losses from early terminations of derivatives are deferred and amortized as yield adjustments over the shorter of the remaining term of the hedged asset or liability or the remaining term of the derivative instrument.  Upon disposition or settlement of the asset or liability being hedged, deferral accounting is discontinued and any gains or losses are recognized in income.  Unrealized holding gains and losses on derivatives designated as cash flow hedges are reported, net of applicable income tax effect, in accumulated other comprehensive income.



Derivative financial instruments that fail to qualify as a hedge are carried at fair value with gains and losses recognized in current earnings.



New Accounting Standards

On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB 105). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments (IRLC), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The adoption of SAB 105 did not have a material impact on the Companys consolidated financial statements.

In March 2004, the Emerging Issues Task Force released EITF Issue 03-01, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments(EITF 03-01).  EITF 03-01 provides guidance for determining whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments. The recognition and measurement guidance for other-than-temporary impairment has been delayed by the issuance of FASB Staff Position EITF 03-1-1 on September 30, 2004.  The adoption of EITF 03-1 did not result in any other-than-temporary impairment of the Companys investments.



In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB 107), which contains guidance on applying the requirements in SFAS No. 123(r). SAB 107 provides guidance on valuation techniques, development of assumptions used in valuing employee share options and related MD&A disclosures. SAB 107 is effective for the period in which SFAS No. 123(r) is adopted. The Company adopted SAB 107 on January 1, 2006, with no material effect on its consolidated financial statements.



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, (SFAS No. 154) which replaces APB Opinion No. 20 Accounting Changes and SFAS No. 3 Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 changes the requirements for the accounting for and reporting of a change in an accounting principle. SFAS No. 154 requires retrospective application for voluntary changes in an accounting principle unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company adopted SFAS No. 154 on January 1, 2006 with no material effect on its consolidated financial statements.







The accompanying notes are an integral part of these consolidated financial statements.

51





---





NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)



In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment, (SFAS No. 123(R)), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation.  SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and amends SFAS No. 95 Statement of Cash Flows.  SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services.  This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions.  SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed.  Prior to SFAS No. 123(R), only certain pro forma disclosures of fair value were required.  The provisions of this Statement are effective for the first annual reporting period that begins after June 15, 2005.  Accordingly, we adopted SFAS No. 123(R) commencing with the quarter ending March 31, 2006. If we had included the cost of employee stock option compensation in our consolidated financial statements, our net income for the fiscal years ended December 31, 2005 and 2004 would have decreased by approximately $88,000 and $64,000 respectively.  Net income of $7.0 million for 2006 includes the effect of implementation of SFAS No. 123(R) of $97,000.



In July 2006, the FASB issued FASB Interpretation No. 48 , Accounting for Uncertainty in Income Taxes, (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in enterprises' financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006.  The Company adopted FIN 48 on January 1, 2007 and is currently analyzing the effects of the interpretation on its consolidated financial statements.



In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No. 157).  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This standard does not require any new fair value measurements, but rather eliminates inconsistencies found in various prior pronouncements. SFAS No. 157 is effective for the Company on January 1, 2008 and is not expected to have a significant impact on the Company's consolidated financial statements.



In September 2006, the FASB issued SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans (SFAS No. 158), which amends SFAS No. 87 and SFASNo. 106 to require recognition of the overfunded or underfunded status of pension and other postretirement benefit plans on the balance sheet. Under SFAS No. 158, gains and losses, prior service costs and credits, and any remaining transition amounts under SFAS No. 87 and SFAS No. 106 that have not yet been recognized through net periodic benefit cost will be recognized in accumulated other comprehensive income, net of tax effects, until they are amortized as a component of net periodic cost. The measurement date  the date at which the benefit obligation and plan assets are measured  is required to be the company's fiscal year end. SFAS No. 158 is effective for publicly-held companies for fiscal years ending after December 15, 2006, except for the measurement date provisions, which are effective for fiscal years ending after December 15, 2008.  The Companys adoption of SFAS No. 158 as of December 31, 2006 had no effect on its consolidated financial statements.







The accompanying notes are an integral part of these consolidated financial statements.

52





---





NOTE A - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(Continued)



In September, 2006, the FASB ratified the consensuses reached by the FASB's Emerging Issues Task Force relating to EITF 06-4 Accounting for the Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements (EITF 06-4). EITF 06-4 states that an employer accounting for endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to postretirement periods should recognize a liability for future benefits in accordance with SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, or APB Opinion No. 12, Omnibus Opinion1967. EITF 06-4 is effective for fiscal years beginning after December 15, 2007.  Entities should recognize the effects of applying this issue through either (a) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption or (b) a change in accounting principle through retrospective application to all prior periods. The Company is currently analyzing the effect of the adoption of EITF 06-4 on its consolidated financial statements.



In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108.  SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a potential current year misstatement. Prior to SAB 108, companies might evaluate the materiality of financial statement misstatements using either the income statement or balance sheet approach, with the income statement approach focusing on new misstatements added in the current year, and the balance sheet approach focusing on the cumulative amount of misstatement present in a company's balance sheet. Misstatements that would be material under one approach could be viewed as immaterial under another approach and not be corrected. SAB 108 now requires that companies view financial statement misstatements as material if they are material according to either the income statement or balance sheet approach. The Company adopted SAB 108 effective for the year ended December 31, 2006 with no impact on the reported results of operations or financial conditions.



Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Companys financial position, results of operations and cash flows.



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



Reclassifications



Certain items included in the 2005 and 2004 consolidated financial statements have been reclassified to conform to the 2006 presentation. These reclassifications have no effect on the net income or shareholders equity previously reported.





The accompanying notes are an integral part of these consolidated financial statements.

53





---





NOTE B - INVESTMENT SECURITIES



The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities available for sale as of December 31, 2006 and 2005 are as follows:



|                                      |                        |         |            |       |            |       |            |     |  |   |        
|------------------------------------- | ---------------------- | ------- | ---------- | ----- | ---------- | ----- | ---------- | --- |  | - | -------
|                                      |                        |         |            | Gross |            | Gross |            |     | 
|                                      | Amortized              |         | Unrealized |       | Unrealized |       |            |    
|                                      | Cost                   |         | Gains      |       | Losses     |       | Fair Value
|2006:                                 | (Amounts in thousands)
|U.S. Government and agency securities | $                      | 85,730  |            | $     | 83         |       | $          | 566 |  | $ | 85,247 
|State and municipal securities        |                        | 4,623   |            |       | 16         |       |            | 30  |  |   | 4,609  
|Mortgage-backed securities            |                        | 9,882   |            |       | 52         |       |            | 74  |  |   | 9,860  
|Other                                 |                        | 1441    |            |       | 236        |       |            | -   |  |   | 1677   
|                                      | $                      | 101,676 |            | $     | 387        |       | $          | 670 |  | $ | 101,393





|                                      |                        |        |            |       |            |       |            |     |  |   |       
|------------------------------------- | ---------------------- | ------ | ---------- | ----- | ---------- | ----- | ---------- | --- |  | - | ------
|                                      |                        |        |            | Gross |            | Gross |            |     | 
|                                      | Amortized              |        | Unrealized |       | Unrealized |       |            |    
|                                      | Cost                   |        | Gains      |       | Losses     |       | Fair Value
|                                      | (Amounts in thousands)
|2005:                                 |                        |        |            |       |            |       |            |     |  |   |       
|U.S. Government and agency securities | $                      | 69,108 |            | $     | 21         |       | $          | 698 |  | $ | 68,431
|State and municipal securities        |                        | 3,963  |            |       | 15         |       |            | 68  |  |   | 3,910 
|Mortgage-backed securities            |                        | 7,003  |            |       | 3          |       |            | 102 |  |   | 6,904 
|Other                                 |                        | 685    |            |       | 279        |       |            | -   |  |   | 964   
|                                      | $                      | 80,759 |            | $     | 318        |       | $          | 868 |  | $ | 80,209



The following table shows gross unrealized losses and fair values of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005.  As of December 31, 2006, the unrealized losses relate to  thirty-six U.S. government agency securities, six mortgage-backed securities and ten municipal securities. Twenty-nine of the U.S. government agency securities, nine of the municipal securities and five of the mortgage backed securities had continuous unrealized losses for more than twelve months. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased.  The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses relate to the marketability of the securities or the issuers ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired.



The accompanying notes are an integral part of these consolidated financial statements.

54





---





NOTE B - INVESTMENT SECURITIES

(Continued)



|                               |                                |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |     |    
|------------------------------ | ------------------------------ | ----------------- | ------------------- | ------ | ----------------- | --- | ----- |  | ---------- | ------ | ----- | -- | ---------- |  | ----- | ------ |  | --- | ---
|                               |                                |                   | 2006               
|                               |                                |                   | Less Than 12 Months |        | 12 Months or More |     | Total
|                               |                                |                   | Fair                |        | Unrealized        |     | Fair  |  | Unrealized |        | Fair  |    | Unrealized
|                               |                                |                   | value               |        | losses            |     | value |  | losses     |        | value |    | losses    
|                               | (Amounts in thousands)         |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |    
|Securities available for sale: |                                |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        | 
|                               | U.S. government and            |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |    
|                               |                                | agency securities | $                   | 11,967 |                   | $   | 22    |  | $          | 48,225 |       | $  | 544        |  | $     | 60,192 |  | $   | 566
|                               | State and municipal securities |                   | 138                 |        |                   | -   |       |  | 2,349      |        |       | 30 |            |  | 2,487 |        |  | 30 
|                               | Mortgage-backed securities     |                   | 549                 |        |                   | -   |       |  | 4,320      |        |       | 74 |            |  | 4,869 |        |  | 74 
|                               |                                |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |     |    
|                               | Total temporarily impaired     |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |    
|                               |                                | securities        | $                   | 12,654 |                   | $   | 22    |  | $          | 54,894 |       | $  | 648        |  | $     | 67,548 |  | $   | 670
|                               |                                |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |     |    
|                               |                                |                   | 2005               
|                               |                                |                   | Less Than 12 Months |        | 12 Months or More |     | Total
|                               |                                |                   | Fair                |        | Unrealized        |     | Fair  |  | Unrealized |        | Fair  |    | Unrealized
|                               |                                |                   | value               |        | losses            |     | value |  | losses     |        | value |    | losses    
|                               | (Amounts in thousands)         |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |    
|Securities available for sale: |                                |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        | 
|                               | U.S. government and            |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |    
|                               |                                | agency securities | $                   | 50,622 |                   | $   | 546   |  | $          | 7,840  |       | $  | 152        |  | $     | 58,462 |  | $   | 698
|                               | State and municipal securities |                   | 2,810               |        |                   | 53  |       |  | 626        |        |       | 15 |            |  | 3,436 |        |  | 68 
|                               | Mortgage-backed securities     |                   | 5,004               |        |                   | 102 |       |  | -          |        |       | -  |            |  | 5,004 |        |  | 102
|                               |                                |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |     |    
|                               | Total temporarily impaired     |                   |                     |        |                   |     |       |  |            |        |       |    |            |  |       |        |  |    
|                               |                                | securities        | $                   | 58,436 |                   | $   | 701   |  | $          | 8,466  |       | $  | 167        |  | $     | 66,902 |  | $   | 868



The amortized cost and fair value of debt securities at December 31, 2006 by contractual maturities are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.



|                                       |                        |         |            |   |        
|-------------------------------------- | ---------------------- | ------- | ---------- | - | -------
|                                       | Amortized              |         |            |  
|                                       | Cost                   |         | Fair Value
|                                       | (Amounts in thousands)
|Due within one year                    | $                      | 2,000   |            | $ | 1,984  
|Due after one year through five years  |                        | 36,092  |            |   | 35,719 
|Due after five years through ten years |                        | 51,563  |            |   | 51,454 
|Due after ten years                    |                        | 12,021  |            |   | 12,236 
|                                       | $                      | 101,676 |            | $ | 101,393



Securities with a carrying value of approximately $69.2 million and $65.2 million at December 31, 2006 and 2005, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.



Sales and calls of securities available for sale during 2006, 2005 and 2004 generated gross realized gains of $14,593, $73,717 and $224,000, respectively and gross realized losses of $135,250, $460,142 and $153,000, respectively.



The accompanying notes are an integral part of these consolidated financial statements.

55





---







NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES



Major classifications of loans as of December 31, 2006 and 2005 are summarized as follows:





|                                    |                        |         |      |   |        
|----------------------------------- | ---------------------- | ------- | ---- | - | -------
|                                    | 2006                   |         | 2005
|                                    | (Amounts in thousands)
|Real estate - residential and other | $                      | 197,195 |      | $ | 177,995
|Real estate - agricultural          |                        | 12,326  |      |   | 11,650 
|Construction and land development   |                        | 194,460 |      |   | 142,592
|Other agricultural                  |                        | 2,724   |      |   | 3,729  
|Consumer loans                      |                        | 16,618  |      |   | 26,371 
|Commercial loans                    |                        | 37,622  |      |   | 34,166 
|Other loans                         |                        | 1,101   |      |   | 909    
|                                    |                        | 462,046 |      |   | 397,412
|Less:                               |                        |         |      |   |        
|Net deferred loan costs             |                        | (283)   |      |   | (318)  
|Allowance for loan losses           |                        | (5,566) |      |   | (4,965)
|                                    | $                      | 456,197 |      | $ | 392,129



Nonperforming assets at December 31, 2006 and 2005 consist of the following:



|                                             |                        |       |      |   |      
|-------------------------------------------- | ---------------------- | ----- | ---- | - | -----
|                                             | 2006                   |       | 2005
|                                             | (Amounts in thousands)
|Loans past due ninety days or more           | $                      | 33    |      | $ | 74   
|Nonaccrual loans                             |                        | 967   |      |   | 997  
|Foreclosed assets (included in other assets) |                        | 327   |      |   | 247  
|                                             | $                      | 1,327 |      | $ | 1,318



During 2005, the Company revised its SFAS 114 methodology for reporting loans.  At December 31, 2006, the recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $5.4 million.  This amount consisted of both accrual and nonaccrual loans in the amount of $4.4 million and $1.0 million, respectively. At December 31, 2005, the investment in loans considered impaired amounted to $3.6 million, which consisted entirely of nonaccrual loans. Impaired loans of $4.4 millionand $3.6 millionhad related allowances for loan losses of $1.7 millionand $1.2 million at December 31, 2006 and 2005, respectively. For the years ended December 31, 2006 and 2005, the average recorded investment in impaired loans was approximately $4.9 million and $3.5 million, respectively.  The amount of interest recognized on impaired loans during the portion of the year that they were impaired was not material.



A summary of the allowance for loan losses for the years ended December 31, 2006, 2005 and 2004 is as follows:



|                                           |                        |       |      |   |       |  |   |        
|------------------------------------------ | ---------------------- | ----- | ---- | - | ----- |  | - | -------
|                                           | 2006                   |       | 2005 |   | 2004 
|                                           | (Amounts in thousands)
|                                           |                        |       |      |   |       |  |   |        
|Balance, beginning                         | $                      | 4,965 |      | $ | 4,055 |  | $ | 3,430  
|Provision for loan losses                  |                        | 873   |      |   | 1,403 |  |   | 1,596  
|Loans charged-off                          |                        | (458) |      |   | (696) |  |   | (1,346)
|Recoveries of loans previously charged-off |                        | 186   |      |   | 203   |  |   | 375    
|Balance, ending                            | $                      | 5,566 |      | $ | 4,965 |  | $ | 4,055  







The accompanying notes are an integral part of these consolidated financial statements.

56





---





NOTE C - LOANS AND ALLOWANCE FOR LOAN LOSSES

(Continued)



The Bank had loan and deposit relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated. The following is a reconciliation of loans directly outstanding to executive officers, directors, and their affiliates (amounts in thousands):



|                             |   |      
|---------------------------- | - | -----
|Balance at December 31, 2005 | $ | 4,101
|New loans                    |   | 3,931
|Principal repayments         |   | (778)
|Balance at December 31, 2006 | $ | 7,254



As a matter of policy, these loans and credit lines are approved by the Companys Board of Directors and are made with interest rates, terms, and collateral requirements comparable to those required of other borrowers. In the opinion of management, these loans do not involve more than the normal risk of collectibility. At December 31, 2006, the Company had pre-approved but unused lines of credit totaling $2.2 million to executive officers, directors and their affiliates.



NOTE D - BANK PREMISES AND EQUIPMENT



Bank premises and equipment at December 31, 2006 and 2005 are as follows:



|                              |                        |         |      |   |        
|----------------------------- | ---------------------- | ------- | ---- | - | -------
|                              | 2006                   |         | 2005
|                              | (Amounts in thousands)
|                              |                        |         |      |   |        
|Land                          | $                      | 2,814   |      | $ | 2,237  
|Buildings                     |                        | 8,410   |      |   | 7,183  
|Furniture and equipment       |                        | 8,383   |      |   | 7,369  
|                              |                        | 19,607  |      |   | 16,789 
|Less accumulated depreciation |                        | (7,977) |      |   | (7,106)
|                              | $                      | 11,630  |      | $ | 9,683  



Depreciation expense for the years ended December 31, 2006 and 2005 amounted to $1.0 million for each year.



As of December 31, 2006, the Company has an outstanding commitment to construct a new branch facility in Zebulon at an estimated cost of $1.2 million.





NOTE E - DEPOSITS



At December 31, 2006, the scheduled maturities of time deposits are as follows (amounts in thousands):



|                                  |           |         |          |   |         |  |   |        
|--------------------------------- | --------- | ------- | -------- | - | ------- |  | - | -------
|                                  | Less than |         | $100,000 |   |         | 
|                                  | $100,000  |         | or more  |   | Total  
|                                  |           |         |          |   |         |  |   |        
|Within one year                   | $         | 98,730  |          | $ | 118,442 |  | $ | 217,172
|Over one year through three years |           | 9,104   |          |   | 45,277  |  |   | 54,381 
|Over three years                  |           | 1,411   |          |   | 778     |  |   | 2,189  
|                                  | $         | 109,245 |          | $ | 164,497 |  | $ | 273,742





The accompanying notes are an integral part of these consolidated financial statements.

57





---





NOTE F - BORROWINGS



At December 31, 2006 and 2005, borrowed funds included the following FHLB advances (amounts in thousands):



|               |  |               |            |      |   |        |  |   |       
|-------------- |  | ------------- | ---------- | ---- | - | ------ |  | - | ------
|Maturity       |  | Interest Rate |            | 2006 |   | 2005  
|               |  |               |            |      |   |        |  |   |       
|March 2006     |  | 4.52%         | - Variable |      | $ | -      |  | $ | 10,000
|June 2008      |  | 5.40%         | - Variable |      |   | 10,000 |  |   | -     
|July 2010      |  | 5.75%         | - Fixed    |      |   | 10,000 |  |   | 10,000
|July 2011      |  | 4.44%         | - Fixed    |      |   | -      |  |   | 5,000 
|September 2011 |  | 4.38%         | - Fixed    |      |   | -      |  |   | 3,000 
|October 2011   |  | 4.30%         | - Fixed    |      |   | -      |  |   | 7,000 
|November 2011  |  | 5.39%         | - Variable |      |   | 8,000  |  |   | -     
|November 2011  |  | 4.56%         | - Variable |      |   | -      |  |   | 8,000 
|August 2015    |  | 3.77%         | - Fixed    |      |   | 10,000 |  |   | 10,000
|October 2015   |  | 3.73%         | - Fixed    |      |   | -      |  |   | 10,000
|May 2016       |  | 4.46%         | - Fixed    |      |   | 5,000  |  |   | -     
|October 2016   |  | 4.01%         | - Fixed    |      |   | 10,000 |  |   | -     
|October 2016   |  | 4.13%         | - Fixed    |      |   | 5,000  |  |   | -     
|November 2016  |  | 4.11%         | - Fixed    |      |   | 5,000  |  |   | -     
|November 2016  |  | 4.09%         | - Fixed    |      |   | 7,000  |  |   | -     
|               |  |               |            |      | $ | 70,000 |  | $ | 63,000



The above advances are secured by a floating lien covering the Companys loan portfolio of qualifying residential (1-4 units) first mortgage loans. At December 31, 2006, the Company has available lines of credit totaling $121.6 million with the FHLB for borrowing dependent on adequate collateralization. The weighted average rates for the above borrowings at December 31, 2006 and 2005 were 4.65% and 4.44%, respectively.  The Company has no short-term FHLB advances outstanding as of December 31, 2006 and $480,000 outstanding at December 31, 2005. A promissory note in the amount of $160,000 that was outstanding at December 31, 2005 was repaid in 2006.



In addition to the above advances, the Company has lines of credit of $32.7 million from various financial institutions to purchase federal funds on a short-term basis.  The Company has $3.4 million outstanding as of December 31, 2006.  The Company had $10.5 million in federal funds outstanding as of December 31, 2005.



NOTE G - TRUST PREFERRED SECURITIES



On March 30, 2006, $12.0 million of trust preferred securities (Trust Preferred Securities) were placed through the Trust.  The Trust has invested the net proceeds from the sale of the Trust Preferred Securities in Junior Subordinated Deferrable Interest Debentures (the Debentures) issued by the Company and recorded in borrowings on the accompanying consolidated balance sheet.  The Trust Preferred Securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 1.35%.  The dividends paid to holders of the Trust Preferred Securities, which will be recorded as interest expense, are deductible for income tax purposes.  The Trust Preferred Securities are redeemable on June 15, 2011 or afterwards in whole or in part, on any June 15, September 15, December 15 or March 15.  Redemption is mandatory by June 15, 2036.  The Company has fully and unconditionally guaranteed the Trust Preferred Securities through the combined operation of the Debentures and other related documents.  The Companys obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.  The Trust Preferred Securities qualify as Tier I capital for regulatory capital purposes subject to certain limitations.



NOTE H - INCOME TAXES



Allocation of income tax expense between current and deferred portions is as follows:



The accompanying notes are an integral part of these consolidated financial statements.

58





---







NOTE H - INCOME TAXES

(Continued)

|                      |         |                          |       |      |   |       |  |   |      
|--------------------- | ------- | ------------------------ | ----- | ---- | - | ----- |  | - | -----
|                      |         | Years Ended December 31,
|                      |         | 2006                     |       | 2005 |   | 2004 
|                      |         | (Amounts in thousands)  
|Current tax expense:  |         |                          |       |      |   |       |  |  
|                      | Federal | $                        | 3,513 |      | $ | 2,947 |  | $ | 2,086
|                      | State   |                          | 433   |      |   | 463   |  |   | 410  
|                      |         |                          | 3,946 |      |   | 3,410 |  |   | 2,496
|Deferred tax expense: |         |                          |       |      |   |       |  |  
|                      | Federal |                          | (269) |      |   | (559) |  |   | (161)
|                      | State   |                          | (50)  |      |   | (113) |  |   | (27) 
|                      |         |                          | (319) |      |   | (672) |  |   | (188)
|                      |         | $                        | 3,627 |      | $ | 2,738 |  | $ | 2,308



The reconciliation of expected income tax at the statutory federal rate of 34% with income tax expense is as follows:



|                                                     |                        |                          |      |   |       |  |   |      
|---------------------------------------------------- | ---------------------- | ------------------------ | ---- | - | ----- |  | - | -----
|                                                     |                        | Years Ended December 31, |      |   |      
|                                                     | 2006                   |                          | 2005 |   | 2004 
|                                                     | (Amounts in thousands)
|                                                     |                        |                          |      |   |       |  |   |      
|Expense computed at statutory rate of 34%            | $                      | 3619                     |      | $ | 2,631 |  | $ | 2,272
|Effect of state income taxes, net of federal benefit |                        | 253                      |      |   | 232   |  |   | 304  
|Tax exempt income                                    |                        | (51)                     |      |   | (36)  |  |   | (101)
|Bank owned life insurance income                     |                        | (187)                    |      |   | (102) |  |   | (152)
|Other, net                                           |                        | (7)                      |      |   | 13    |  |   | (15) 
|                                                     | $                      | 3,627                    |      | $ | 2,738 |  | $ | 2,308



Deferred income taxes consist of the following:



|                          |                                 |                                |                          |       |      |       |      
|------------------------- | ------------------------------- | ------------------------------ | ------------------------ | ----- | ---- | ----- | -----
|                          |                                 |                                | Years Ended December 31,
|                          |                                 |                                | 2006                     |       | 2005
|                          |                                 |                                | (Amounts in thousands)  
|Deferred tax assets:      |                                 |                                |                          |       |     
|                          | Allowance for loan losses       | $                              | 2,101                    |       | $    | 1,870
|                          | Non-qualified stock options     |                                | 60                       |       |      | -    
|                          | Unamortized investment premiums |                                | 1                        |       |      | 5    
|                          | Net deferred loan fees          |                                | 109                      |       |      | 123  
|                          | Derivatives                     |                                | -                        |       |      | 217  
|                          | Other comprehensive income      |                                | 273                      |       |      | 506  
|                          | Other                           |                                | 57                       |       |      | 47   
|                          |                                 | Total deferred tax assets      |                          | 2,601 |      |       | 2,768
|                          |                                 |                                |                          |       |      |       |      
|Deferred tax liabilities: |                                 |                                |                          |       |     
|                          | Property and equipment          |                                | 641                      |       |      | 718  
|                          | Prepaid expense                 |                                | 105                      |       |      | 81   
|                          | Unaccreted investment discounts |                                | 20                       |       |      | 3    
|                          |                                 | Total deferred tax liabilities |                          | 766   |      |       | 802  
|                          |                                 | Net deferred tax assets        | $                        | 1,835 |      | $     | 1,966





The accompanying notes are an integral part of these consolidated financial statements.

59





---





NOTE I - REGULATORY RESTRICTIONS



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



Current Federal regulations require that the Bank maintain a minimum ratio of total capital to risk weighted assets of 8%, with at least 4% being in the form of Tier 1 capital, as defined in the regulations. In addition, the Bank must maintain a leverage ratio of 4%. As of December 31, 2006, the Banks capital exceeded the current capital requirements. The Bank currently expects to continue to exceed these minimums without altering current operations or strategy.



The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2006, that the Bank meets all capital adequacy requirements to which it is subject.



As of December 31, 2006, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Banks category.



The Banks actual capital amounts and ratios are also presented in the table below (dollars in thousands, except ratios):



|                                         |   |        |  |                   |   |                   |  |                   |   |            |  |       
|---------------------------------------- | - | ------ |  | ----------------- | - | ----------------- |  | ----------------- | - | ---------- |  | ------
|                                         |   |        |  |                   |   |                   |  |                   |   | Minimum   
|                                         |   |        |  |                   |   |                   |  |                   |   | To Be Well
|                                         |   |        |  |                   |   | Minimum           |  | Capitalized Under
|                                         |   |        |  |                   |   | For Capital       |  | Prompt Corrective
|                                         |   | Actual |  | Adequacy Purposes |   | Action Provisions
|                                         |   | Amount |  | Ratio             |   | Amount            |  | Ratio             |   | Amount     |  | Ratio 
|As of December 31, 2006:                 |   |        |  |                   |   |                   |  |                   |   |            |  |       
|Total Capital (to Risk Weighted Assets)  | $ | 61,618 |  | 12.79%            | $ | 38,543            |  | 8.00%             | $ | 48,179     |  | 10.00%
|Tier I Capital (to Risk Weighted Assets) |   | 56,052 |  | 11.63%            |   | 19,272            |  | 4.00%             |   | 28,908     |  | 6.00% 
|Tier I Capital (to Average Assets)       |   | 56,052 |  | 9.30%             |   | 24,072            |  | 4.00%             |   | 30,090     |  | 5.00% 
|                                         |   |        |  |                   |   |                   |  |                   |   |            |  |       
|As of December 31, 2005:                 |   |        |  |                   |   |                   |  |                   |   |            |  |       
|Total Capital (to Risk Weighted Assets)  | $ | 42,682 |  | 10.40%            | $ | 33,837            |  | 8.00%             | $ | 41,046     |  | 10.00%
|Tier I Capital (to Risk Weighted Assets) |   | 37,717 |  | 9.20%             |   | 16,418            |  | 4.00%             |   | 24,628     |  | 6.00% 
|Tier I Capital (to Average Assets)       |   | 37,717 |  | 7.70%             |   | 19,694            |  | 4.00%             |   | 24,617     |  | 5.00% 



The Company is also subject to these capital requirements. At December 31, 2006 and 2005, the Companys total capital to risk weighted assets, Tier 1 capital to risk weighted assets and Tier 1 capital to average assets were 12.87%, 14.02%, and 10.29% and 11.5%, 13.0%, and 10.3%, respectively.





The accompanying notes are an integral part of these consolidated financial statements.

60





---





NOTE J - DERIVATIVES

Derivative Financial Instruments



The Company has stand-alone derivative financial instruments in the form of interest rate swap agreements, which derive their value from underlying interest rates.  These transactions involve both credit and market risk.  The notional amounts are amounts on which calculations, payments, and the value of the derivative are based.  Notional amounts do not represent direct credit exposures.  Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any.  Such difference, which represents the fair value of the derivative instruments, is reflected on the Companys consolidated balance sheets as derivative assets and derivative liabilities.



The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements.  The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations.  The Company deals only with primary dealers.



Derivative instruments are generally either negotiated over-the-counter (OTC) contracts or standardized contracts executed on a recognized exchange.  Negotiated OTC derivative contracts are generally entered into between two counterparties that negotiate specific agreements terms, including the underlying instruments, amount, exercise prices and maturity.



Risk Management Policies - Hedging Instruments



The primary focus of the Companys asset/liability management program is to monitor the sensitivity of the Companys net portfolio value and net income under varying interest rate scenarios to take steps to control its risks.  On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned over a twelve-month period following the date of simulation.  The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period.  Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates.  The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates.



Interest Rate Risk Management - Cash Flow Hedging Instruments



The Company originates variable rate loans for its loan portfolio.  These loans expose the Company to variability in cash flows, primarily from interest receipts due to changes to interest rates.  If interest rates increase, interest income increases.  Conversely, if interest rates decrease, interest income decreases.  Management believes it is prudent to limit the variability of a portion of its cash flows on variable rate loans therefore, generally hedges a portion of its variable-rate receipts.  To meet this objective, management enters into interest rate swap agreements whereby the Company receives fixed rate payments and makes variable rate payments during the contract period.



At December 31, 2006 and 2005, the information pertaining to an outstanding interest rate swap agreement used to hedge variable rate loans is as follows (dollars in thousands):



|                                                |      |        |      |   |       
|----------------------------------------------- | ---- | ------ | ---- | - | ------
|                                                | 2006 |        | 2005
|Notional amount                                 | $    | 25,000 |      | $ | 25,000
|Weighted average pay rate                       |      | 7.96%  |      |   | 6.09% 
|Weighted average receive rate                   |      | 5.85%  |      |   | 5.85% 
|Weighted average maturity in years              |      | 0.7    |      |   | 1.7   
|Unrealized loss relating to interest rate swaps | $    | (402)  |      | $ | (716) 





This agreement requires the Company to make payments at a variable rate determined by a specified index (prime) in exchange for receiving payments at a fixed rate.







The accompanying notes are an integral part of these consolidated financial statements.

61





---





NOTE J  DERIVATIVES

(Continued)



At December 31, 2006 and 2005, the Companys interest rate swap used to hedge variable rate loans reflected an unrealized loss of $402,000 and $716,000, respectively.  The unrealized losses are included in other comprehensive income, net of tax, in the accompanying consolidated balance sheet.



Risk management results for the years ended December 31, 2006 and 2005 related to the balance sheet hedging of variable rate loans indicate that the hedge was 100% effective and that there was no component of the derivative instruments gain or loss which was excluded from the assessment of hedge effectiveness.



At December 31, 2006 and 2005, the unrealized loss relating to use of the interest rate swap was recorded in derivative liabilities in accordance with SFAS No. 133.  Changes in the fair value of interest rate swaps designated as hedging instruments of the variability of cash flows associated with variable rate loans are reported in other comprehensive income.



Interest Rate Risk Management - Fair Value Hedging Instruments



The Company uses funds from fixed rate time deposits in its lending and investment activities and for other general purposes.  These debt obligations expose the Company to variability in their fair value due to changes in the level of interest rates.  Management believes that it is prudent to limit the variability in the fair value of a portion of its fixed-rate funding.  It is the Companys objective to hedge the change in fair value of fixed-rate funding coverage levels that are appropriate, given anticipated or existing interest rate levels and other market considerations, as well as the relationship of change in this liability to other liabilities of the Company.  To meet this objective, the Company utilized interest rate swaps as an asset/liability management strategy to hedge the change in value of the funding due to changes in expected interest rate assumptions.  These interest rate swap agreements are contracts to make a series of floating rate payments in exchange for receiving a series of fixed rate payments.



At December 31, 2006 and 2005, the information pertaining to outstanding interest rate swap agreements used to hedge fixed-rate funding is as follows (dollars in thousands):



|                                                       |      |        |      |   |       
|------------------------------------------------------ | ---- | ------ | ---- | - | ------
|                                                       | 2006 |        | 2005
|                                                       |      |        |      |   |       
|Notional amount                                        | $    | 38,611 |      | $ | 38,711
|Weighted average pay rate                              |      | 5.32%  |      |   | 4.28% 
|Weighted average receive rate                          |      | 3.90%  |      |   | 3.73% 
|Weighted average maturity in years                     |      | 3.1    |      |   | 4.4   
|Unrealized gain (loss) relating to interest rate swaps | $    | (145)  |      | $ | (240) 



These agreements require the Company to make payments at variable-rate determined by a specified index (LIBOR) in exchange for receiving payments at a fixed-rate.



No interest rate swaps were terminated during 2006 or 2005. During 2004, an interest rate swap was called at par, with no corresponding gain or loss recognized.At December 31, 2006 and 2005, the Companys interest rate swaps used to hedge fixed-rate funding reflected an unrealized loss of $145,000 and $240,000, respectively. At December 31, 2006 and 2005, the Companys interest rate swaps not designated as a fair value hedge reflected a realized loss of $262,000 and $397,000, respectively. The above interest rate swaps are recorded in other liabilities in the accompanying consolidated balance sheet.



NOTE K - COMMITMENTS AND CONTINGENCIES



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



The accompanying notes are an integral part of these consolidated financial statements.

62





---







NOTE K - COMMITMENTS AND CONTINGENCIES

(Continued)



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



Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers.  These lines of credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed.



Stand-by letters of credit are conditional lending commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those letters of credit are primarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued have expiration dates within one year.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.



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



Financial instruments whose contract amounts represent credit risk:



|                                       |   |       
|-------------------------------------- | - | ------
|Commitments to extend credit           | $ | 98,068
|Undisbursed lines of credit            |   | 42,471
|Financial stand-by letters of credit   |   | 675   
|Performance stand-by letters of credit |   | 4,036 



NOTE L - STOCK OPTION PLAN



The Company has a non-qualified stock option plan for certain key employees under which it is authorized to issue options for up to 1,220,703 shares of common stock. Options are granted at the discretion of the Companys Board of Directors at a price approximating market, as determined by a committee of Board members. All options granted subsequent to a 1997 amendment will be 100% vested one year from the grant date and will expire after such a period as is determined by the Board at the time of grant. Options granted prior to the amendment have ten year lives and a five year level vesting provision.







The accompanying notes are an integral part of these consolidated financial statements.

63





---







NOTE L - STOCK OPTION PLAN

(Continued)



A summary of the status of the Companys stock options, after giving retroactive effect to stock splits, as of December 31, 2006, 2005 and 2004, and changes during the years ending on those dates is presented below:



|                          |             |  |              
|------------------------- | ----------- |  | -------------
|                          | Options     |  | Option Price 
|                          | Outstanding |  | Per Share    
|                          |             |  |              
|Balance December 31, 2003 | 239,843     |  | $4.73  9.22 
|                          |             |  |              
|Granted                   | 52,930      |  | $11.27       
|Exercised                 | (96,660)    |  | $8.40        
|Forfeited                 | (1)         |  | $8.20        
|Expired                   | (11)        |  | $8.47        
|Balance December 31, 2004 | 196,101     |  | $4.73  11.26
|                          |             |  |              
|Granted                   | 48,593      |  | $18.20       
|Exercised                 | (51,055)    |  | $10.69       
|Forfeited                 | (4,151)     |  | $12.72       
|Expired                   | (748)       |  | $10.24       
|                          |             |  |              
|Balance December 31, 2005 | 188,740     |  | $4.73  14.56
|                          |             |  |              
|Granted                   | 41,750      |  | $18.40       
|Exercised                 | (67,769)    |  | $9.53        
|Forfeited                 | (781)       |  | $14.56       
|Expired                   | (750)       |  | $8.19        
|Balance December 31, 2006 | 161,190     |  | $4.73  14.56



The weighted average exercise price of all exercisable options at December 31, 2006 is $11.46. There were 418,555 shares reserved for future issuance at December 31, 2006.



The total instrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 was $768,000, $719,000 and $1.06 million, respectively.  The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2006 was $2.17 million and $1.83 million, respectively.  As of December 31, 2006, there was $143,000 of unrecognized compensation cost related to non-vested share-based compensation arrangements.  That cost is expected to be recognized in 2007.



Additional information concerning the Companys stock options at December 31, 2006 is as follows:



|               |             |        |            |             |             |        |  |  |  |  |  | 
|-------------- | ----------- | ------ | ---------- | ----------- | ----------- | ------ |  |  |  |  |  | 
|               |             |        | Remaining  |             |            
|               |             | Number |            | Contractual |             | Number
|Exercise Price | Outstanding |        | Life       |             | Exercisable
|               |             |        |            |             |            
|$4.73          | 6,043       |        | .21 years  |             | 6,043      
|$9.22          | 31,929      |        | .16 years  |             | 31,929     
|$11.26         | 42,677      |        | 1.15 years |             | 42,677     
|$14.56         | 38,791      |        | 2.15 years |             | 38,791     
|$18.40         | 41,750      |        | 3.15 years |             | -          
|               | 161,190     |        |            |             | 119,440    





The accompanying notes are an integral part of these consolidated financial statements.

64





---







NOTE L - STOCK OPTION PLAN

(Continued)



The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 2006, 2005 and 2004:



|                        |         |  |         |  |        
|----------------------- | ------- |  | ------- |  | -------
|                        | 2006    |  | 2005    |  | 2004   
|                        |         |  |         |  |        
|Dividend yield          | 1.53%   |  | 1.84%   |  | 2.06%  
|Expected volatility     | 20.72%  |  | 24.31%  |  | 21.92% 
|Risk free interest rate | 4.73%   |  | 3.75%   |  | 3.00%  
|Expected life           | 4 years |  | 4 years |  | 4 years



The weighted average fair value of options granted during 2006, 2005 and 2004 was $3.84, $3.04, and $1.97, respectively.



NOTE M - OTHER EMPLOYEE BENEFITS



Supplemental Retirement



In 1998, the Companys subsidiary, Four Oaks Bank & Trust Company, adopted a Supplemental Executive Retirement Plan (SERP) for its president. The Company has purchased life insurance policies in order to provide future funding of benefit payments. SERP benefits will accrue and vest during the period of employment and will be paid in annual benefit payments over the officers remaining life commencing with the officers retirement. The liability accrued under the SERP plan amounts to $147,000 and $122,000 at December 31, 2006 and 2005, respectively.  During 2006, 2005, and 2004, the expense attributable to the SERP amounted to $25,000, $23,000, and $20,000, respectively.



Employment Agreements



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



Defined Contribution Plan



The Company sponsors a contributory profit-sharing plan in effect for substantially all employees.  Participants may make voluntary contributions resulting in salary deferrals in accordance with Section 401(k) of the Internal Revenue Code.  The plans provide for employee contributions up to $15,000 of the participant's annual salary and an employer contribution of 25% matching of the first 6% of pre-tax salary contributed by each participant.  Expenses related to these plans for the years ended December 31, 2006, 2005 and 2004 were $66,000, $79,000, and $47,000, respectively.  Contributions under the plan are made at the discretion of the Companys Board of Directors.





The accompanying notes are an integral part of these consolidated financial statements.

65





---





NOTE M - OTHER EMPLOYEE BENEFITS

(Continued)



Employee Stock Ownership Plan



The Company sponsors an employee stock ownership plan (ESOP) which makes the employees of a company, owners of stock in the company.  The Four Oaks Bank & Trust Companys Employee Stock Ownership Trust is available to full-time employees at least 21 years of age after six months of service.  Contributions are voluntary by the Company and employees cannot contribute.  Stock issued is purchased on the open market and the Company does not issue new shares in conjunction with this plan.  Voluntary contributions are determined by the Companys Board of Directors annually based on Company performance and are allocated to employees based on annual compensation.  Contribution expenses for this plan for 2006, 2005, and 2004 were $249,000, $223,000 and $180,000, respectively.



Employee Stock Purchase and Bonus Plan



The Employee Stock Purchase and Bonus Plan (the Purchase Plan) is a voluntary plan that enables full-time employees of the Company and its subsidiaries to purchase shares of the Companys common stock.  The Purchase Plan is administered by a committee of the Board of Directors, which has broad discretionary authority to administer the Purchase Plan.  The Companys Board of Directors may amend or terminate the Purchase Plan at any time.  The Purchase Plan is not intended to be qualified as an employee stock purchase plan under Section 423 of the Internal Revenue Code of 1986, as amended.



Once a year, participants in the Purchase Plan purchase the Companys common stock at fair market value. Participants are permitted to purchase shares under the Purchase Plan up to (5%) of their compensation, with a maximum purchase amount of $1,000 per year.  The Company matches, in cash, fifty percent (50%) of the amount of each participants purchase, up to $500.  After withholding for income and employment taxes, participants use the balance of the Companys matching grant to purchase shares of the Companys common stock.



As of December 31, 2006, 244,141 shares of the Companys common stock had been reserved for issuance under the Purchase Plan, and 149,639shares had been purchased.  During the years ended December 31, 2006 and 2005, 7,776 and 6,872 shares, respectively, were purchased under the Purchase Plan.



NOTE N - LEASES



The Bank has entered into non-cancelable operating leases for three branch facilities.  Future minimum lease payments under the leases for future years are as follows (amounts in thousands):



|                |   |      
|--------------- | - | -----
|2007            | $ | 123  
|2008            |   | 104  
|2009            |   | 97   
|2010            |   | 91   
|2011            |   | 94   
|2012 and beyond |   | 407  
|                | $ | 1,013



In addition, the Bank has leased a building from one of its directors for $970 and $938 per month in 2006 and 2005, respectively under an operating lease on a month-to-month basis. The building lease for the temporary Zebulon branch office is also operating on a month-to-month lease of $1,000 per month, the permanent location should be completed in 2007.



Total rental expense under operating leases for the years ended December 31, 2006, 2005 and 2004 amounted to $116,000 and $57,000 and $45,000, respectively.





The accompanying notes are an integral part of these consolidated financial statements.

66





---





NOTE O - PARENT COMPANY FINANCIAL INFORMATION



Condensed financial information of Four Oaks Fincorp, Inc., the parent company, at December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004 is presented below:



|                                      |                                            |        |        |                        |        |        |  | 
|------------------------------------- | ------------------------------------------ | ------ | ------ | ---------------------- | ------ | ------ |  | 
|                                      |                                            |        |        | 2006                   |        | 2005  
|                                      |                                            |        |        | (Amounts in thousands)
|Condensed Balance Sheets              |                                            |        |        |                        |       
|                                      |                                            |        |        |                        |        |        |  | 
|Assets:                               |                                            |        |        |                        |        |        | 
|Cash and cash equivalents             | $                                          | 4,409  |        | $                      | 3,940 
|Equity investment in subsidiaries     |                                            | 56,324 |        |                        | 37,116
|Securities available for sale         |                                            | 1,015  |        |                        | 668   
|Other Assets                          |                                            |        | 76     |                        |        | -     
|                                      | Total assets                               | $      | 61,824 |                        | $      | 41,724
|                                      |                                            |        |        |                        |        |        |  | 
|Liabilities and Shareholders Equity: |                                            |        |        |                        |       
|Liabilities:                          |                                            |        |        |                        |       
|                                      | Other liabilities                          | $      | 129    |                        | $      | 112   
|                                      | Subordinated debentures                    |        | 12,372 |                        |        | -     
|                                      |                                            |        |        |                        |        |        |  | 
|Shareholders' equity                  |                                            | 49,323 |        |                        | 41,612
|                                      | Total liabilities and shareholders equity | $      | 61,824 |                        | $      | 41,724





|                                   |                        |       |      |   |       |  |   |      
|---------------------------------- | ---------------------- | ----- | ---- | - | ----- |  | - | -----
|                                   | 2006                   |       | 2005 |   | 2004 
|                                   | (Amounts in thousands)
|Condensed Statements of Operations |                        |       |      |   |       |  |   |      
|Equity in earnings of subsidiaries | $                      | 7,469 |      | $ | 4,972 |  | $ | 4,361
|Interest income                    |                        | 187   |      |   | 81    |  |   | 30   
|Other investment income            |                        | 65    |      |   | 17    |  |   | 15   
|Miscellaneous expenses             |                        | (704) |      |   | (67)  |  |   | (31) 
|Net income                         | $                      | 7,017 |      | $ | 5,003 |  | $ | 4,375





The accompanying notes are an integral part of these consolidated financial statements.

67





---







NOTE O - PARENT COMPANY FINANCIAL INFORMATION (Continued)



|                                             |                                                   |                                                    |                        |          |       |         |      |       |         |      
|-------------------------------------------- | ------------------------------------------------- | -------------------------------------------------- | ---------------------- | -------- | ----- | ------- | ---- | ----- | ------- | -----
|                                             |                                                   |                                                    | 2006                   |          | 2005  |         | 2004
|                                             |                                                   |                                                    | (Amounts in thousands)
|Condensed Statements of Cash Flows           |                                                   |                                                    |                        |          |       |         |      |      
|                                             |                                                   |                                                    |                        |          |       |         |      |       |         |      
|Operating activities:                        |                                                   |                                                    |                        |          |       |         |      |      
|                                             | Net income                                        | $                                                  | 7,017                  |          | $     | 5,003   |      | $     | 4,375  
|                                             | Equity in undistributed earnings of subsidiaries  |                                                    | (7,469)                |          |       | (4,972) |      |       | (4,361)
|                                             | (Increase) in other assets                        |                                                    | (76)                   |          |       | -       |      |       | -      
|                                             | Increase in other liabilities                     |                                                    | 17                     |          |       | -       |      |       | -      
|                                             |                                                   | Cash flows (used) provided by operating activities |                        | (511)    |       |         | 31   |       |         | 14   
|Investing activities:                        |                                                   |                                                    |                        |          |       |         |      |      
|                                             | Investment in subsidiaries                        |                                                    | (12,695)               |          |       | -       |      |       | -      
|                                             | Purchase of securities available for sale         |                                                    | (347)                  |          |       | (53)    |      |       | (14)   
|                                             | Upstream dividend received from subsidiary        |                                                    | 1,448                  |          |       | 937     |      |       | 1,089  
|                                             |                                                   | Cash flows (used) provided by investing activities |                        | (11,594) |       |         | 884  |       |         | 1,075
|                                             |                                                   |                                                    |                        |          |       |         |      |       |         |      
|Financing activities:                        |                                                   |                                                    |                        |          |       |         |      |      
|                                             | Proceeds from issuance of common stock            |                                                    | 1,609                  |          |       | 1,230   |      |       | 1,430  
|                                             | Excess tax benefits from stock options            |                                                    | 293                    |          |       | -       |      |       | -      
|                                             | Proceeds from issuance of subordinated debentures |                                                    | 12,372                 |          |       | -       |      |       | -      
|                                             | Purchases and retirements of common stock         |                                                    | (252)                  |          |       | -       |      |       | (65)   
|                                             | Dividends paid                                    |                                                    | (1,448)                |          |       | (1,279) |      |       | (1,089)
|                                             |                                                   | Cash flows (used) provided by financing activities |                        | 12,574   |       |         | (49) |       |         | 276  
|                                             |                                                   |                                                    |                        |          |       |         |      |       |         |      
|                                             |                                                   | Net increase in cash and cash equivalents          |                        | 469      |       |         | 866  |       |         | 1,365
|                                             |                                                   |                                                    |                        |          |       |         |      |       |         |      
|Cash and cash equivalents, beginning of year |                                                   | 3,940                                              |                        |          | 3,074 |         |      | 1,709
|                                             |                                                   |                                                    |                        |          |       |         |      |       |         |      
|Cash and cash equivalents, end of year       | $                                                 | 4,409                                              |                        | $        | 3,940 |         | $    | 3,074





NOTE P - FAIR VALUE OF FINANCIAL INSTRUMENTS



SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Companys financial instruments, the fair value of such instruments has been derived based on managements assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments values and should not be considered an indication of the fair value of the Company taken as a whole. The following methods and assumptions were used to estimate the fair value of each class of financial instrument.



Cash and Cash Equivalents



The carrying amounts of cash and cash equivalents are equal to the fair value due to the liquid nature of the financial instruments.





The accompanying notes are an integral part of these consolidated financial statements.

68





---





NOTE P - FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)



Investment Securities Available for Sale



Fair values of investment securities available for sale are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.



Loans



Fair values have been estimated by type of loan: residential real estate loans, consumer loans, and commercial and other loans. For variable-rate loans that reprice frequently and with no significant credit risk, fair values are based on carrying values. The fair values of fixed rate loans are estimated by discounting the future cash flows using the current rates at which loans with similar terms would be made to borrowers with similar credit ratings and for the same remaining maturities. The Company has assigned no fair value to off-balance sheet financial instruments since they are either short term in nature or subject to immediate repricing.



FHLB Stock



The carrying amount of FHLB stock approximates fair value.



Investment in Life Insurance



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



Deposits



The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at year-end. Fair value of time deposits is estimated by discounting the future cash flows using the current rate offered for similar deposits with the same maturities.



Borrowings and Subordinated Debentures



The fair values are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collection requirements.



Accrued Interest Receivable and Payable



The carrying amounts of accrued interest approximate fair value.



Derivative Financial Instruments



Fair values for interest rate swap agreements are based upon the amounts required to settle the contracts.





The accompanying notes are an integral part of these consolidated financial statements.

69





---





NOTE P - FAIR VALUE OF FINANCIAL INSTRUMENTS  (Continued)



The following table presents information for financial assets and liabilities as of December 31, 2006 and 2005 (amounts in thousands):



|                                  |                                |          |         |            |        |          |  |            |         |  |   |        
|--------------------------------- | ------------------------------ | -------- | ------- | ---------- | ------ | -------- |  | ---------- | ------- |  | - | -------
|                                  |                                | 2006     |         | 2005      
|                                  |                                | Carrying |         | Estimated  |        | Carrying |  | Estimated 
|                                  |                                | Value    |         | Fair Value |        | Value    |  | Fair Value
|Financial assets:                 |                                |          |         |            |        |          |  |            |         |  |  
|                                  | Cash and cash equivalents      | $        | 17,711  |            | $      | 17,711   |  | $          | 22,915  |  | $ | 22,915 
|                                  | Securities available for sale  |          | 101,393 |            |        | 101,393  |  |            | 80,209  |  |   | 80,209 
|                                  | Loans, net                     |          | 456,197 |            |        | 449,550  |  |            | 392,129 |  |   | 388,515
|                                  | FHLB stock                     |          | 4,194   |            |        | 4,194    |  |            | 3,655   |  |   | 3,655  
|                                  | Investment in life insurance   |          | 8,424   |            |        | 8,424    |  |            | 7,875   |  |   | 7,875  
|                                  | Accrued interest receivable    |          | 3,614   |            |        | 3,614    |  |            | 2,950   |  |   | 2,950  
|                                  |                                |          |         |            |        |          |  |            |         |  |   |        
|Financial liabilities:            |                                |          |         |            |        |          |  |            |         |  |  
|Deposits                          |                                | $        | 466,868 |            | $      | 449,771  |  | $          | 398,341 |  | $ | 375,517
|Subordinated debentures           |                                | 12,372   |         |            | 12,384 |          |  | -          |         |  | -
|                                  | Borrowings                     |          | 73,400  |            |        | 74,042   |  |            | 74,140  |  |   | 73,651 
|                                  | Accrued interest payable       |          | 3,258   |            |        | 3,258    |  |            | 2,255   |  |   | 2,255  
|                                  |                                |          |         |            |        |          |  |            |         |  |   |        
|Derivative financial instruments: |                                |          |         |            |        |          |  |            |         |  |  
|                                  | Interest rate swap agreements: |          |         |            |        |          |  |            |         |  |   |        
|                                  | Liabilities, net loss          |          | 1,108   |            |        | 1,108    |  |            | 1,765   |  |   | 1,765  



NOTE Q - CASH FLOW SUPPLEMENTAL DISCLOSURES



The following information is supplemental information regarding the cash flows for the years ended December 31, 2006, 2005 and 2004:

|                                                       |                                                                  |   |                        |   |       |   |      
|------------------------------------------------------ | ---------------------------------------------------------------- | - | ---------------------- | - | ----- | - | -----
|                                                       |                                                                  |   | 2006                   |   | 2005  |   | 2004 
|                                                       |                                                                  |   | (Amounts in thousands)
|Cash paid for:                                         |                                                                  |   |                        |   |       |  
|                                                       | Interest on deposits and borrowings                              | $ | 16,814                 | $ | 8,929 | $ | 5,894
|                                                       | Income taxes                                                     |   | 4,057                  |   | 3,684 |   | 2,192
|                                                       |                                                                  |   |                        |   |       |   |      
|Summary of noncash investing and financing activities: |                                                                  |   |                        |   |       |  
|                                                       | Transfer from loans to foreclosed assets                         |   | 269                    |   | 431   |   | 1,214
|                                                       | Loans to facilitate the sale of foreclosed assets                |   | -                      |   | -     |   | 393  
|                                                       |                                                                  |   |                        |   |       |   |      
|                                                       | Tax benefit from the exercise of non-qualified                   |   |                        |   |       |   |      
|                                                       | stock options                                                    |   | 293                    |   | 101   |   | 94   
|                                                       |                                                                  |   |                        |   |       |   |      
|                                                       | Increase (decrease) in fair value of securities                  |   |                        |   |       |   |      
|                                                       | available for sale, net of tax                                   |   | 161                    |   | (565) |   | (108)
|                                                       |                                                                  |   |                        |   |       |   |      
|                                                       | Increase (decrease) in fair value of cash flow hedge, net of tax |   | 187                    |   | (173) |   | (222)





The accompanying notes are an integral part of these consolidated financial statements.

70





---





NOTE R - STOCK PURCHASE PLAN



On December 10, 2001, the Companys Board of Directors approved a Stock Purchase Program authorizing the Company to purchase up to 100,000 shares, or approximately 4.7% of the then outstanding shares of common stock.  During 2004, the Company purchased 2,800 shares at an average cost of $23.25 per share. The 2004 purchase amount does not reflect the five-for-four stock split during 2004 to shareholders of record as of October 15, 2004, payable on or after October 29, 2004, nor the five-for-four stock split to shareholders of record as of November 9, 2005, payable on or after November 25, 2005, nor the five-for-four stock split to shareholders of record as of October 30, 2006, payable on or after November 10, 2006. During 2006, the Company purchased 9,835 shares at an average cost of $24.08. On December 20, 2006, the Board of Directors authorized the extension of the Companys Stock Purchase Program through December 31, 2007 and increased the purchase authorization to 200,000 shares.



The accompanying notes are an integral part of these consolidated financial statements.

71





---





Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.



Not Applicable.



Item 9A - Controls and Procedures.



Disclosure Controls and Procedures



As required by paragraph (b) of Rule 13a-15 under the Securities  Exchange Act of 1934, as amended (the Exchange Act), an evaluation was carried out under the supervision and with the participation of the Companys management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Companys disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Annual Report.   As defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commissions (the SECs) rules and forms.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.  Based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this Annual Report, the Companys disclosure controls and procedures are effective, in that they provide reasonable assurances that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods required by the SECs rules and forms.





Managements Report on Internal Control Over Financial Reporting



The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting.  The Companys internal control system was designed to provide reasonable assurance to its management and board of directors regarding the preparation and fair presentation of published financial statements.



All internal control systems, no matter how well designed, have inherent limitations.  Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.



The Companys management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2006.  In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control  Integrated Framework.  Based on that assessment, we believe that, as of December 31, 2006, the Company maintained effective internal control over financial reporting based on those criteria.



Four Oaks independent auditors have issued an audit report on our assessment and on the Companys internal control over financial reporting.  This report appears on page 73.



Changes in Internal Control Over Financial Reporting



There have been no changes in the Companys internal control over financial reporting (as such term is defined in Rules 13d-15(f) and 15(d)-15(f) under the Exchange Act) that occurred during the fourth quarter of 2006 that the Company believes have materially affected or is likely to materially affect, its internal control over financial reporting.







72



---







REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



To the Board of Directors and Stockholders

Four Oaks Fincorp, Inc. and Subsidiaries



We have audited management's assessment, included in the accompanying Managements Annual Report on Internal Control Over Financial Reporting, that Four Oaks Fincorp, Inc. and subsidiaries (the Company) maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Companys management is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internal control overfinancial reporting.  Our responsibility is to express an opinion on management'sassessment and an opinion on the effectiveness of the Company's internal control overfinancial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinion.



A Company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A Company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31 2006, is fairly stated, in all material respects, based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.



We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Four Oaks Fincorp, Inc. and subsidiaries as of and for the year ended December 31, 2006, and our report dated March 14, 2007, expressed an unqualified opinion on those consolidated financial statements.



/s/ Dixon Hughes PLLC

Dixon Hughes

Sanford, North Carolina

March 14, 2007

















73



---





Item 9B  Other Information.

Not Applicable.





74



---









PART III



This Part incorporates certain information from the definitive proxy statement (the 2007 Proxy Statement) for the Companys 2007 Annual Meeting of Shareholders, to be filed with the SEC within 120 days after the end of the Companys fiscal year.



Item 10  Directors, Executive Officers and Corporate Governance.



Director information is incorporated by reference from the sections entitled Information about Our Board of Directors, Election of Directors, and under the section entitled Section 16(a) Beneficial Ownership Reporting Compliance, in the 2007 Proxy Statement.  Information on our executive officers is included under the caption Our Executive Officers on Page 9 of this report.  Information about our Code of Ethics is incorporated by reference from the section entitled Code of Ethics, in the 2007 Proxy Statement.  

Information about the procedures by which shareholder nominations to our board of directors may be submitted, including material changes to such procedures, if any, is incorporated by reference from the section entitled Information About our Board of Directors Board CommitteesThe Corporate Governance and Nominating Committee in the 2007 Proxy Statement.  Information regarding the Companys audit committee is hereby incorporated by reference from the section entitled Information About our Board of DirectorsBoard CommitteesThe Audit Committee in the 2007 Proxy Statement.





Item 11 - Executive Compensation.



This information is incorporated by reference from the section entitled Executive Compensation and Compensation Committee Interlocks and Insider Participation in the 2007 Proxy Statement.





Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.



This information is incorporated by reference from the section entitled Security Ownership of Management and Certain Beneficial Owners and the sections entitled Equity Compensation Plan Information, Nonqualified Stock Option Plan and Employee Stock Purchase and Bonus Plan in the 2007 Proxy Statement.



Item 13 - Certain Relationships and Related Transactions, and Director Independence.



Information about certain relationships and related transactions

 is incorporated by reference from the section entitled Certain Transactions in the 2

007 Proxy Statement.  Information about director independence is incorporated by reference from the section entitled Information About our Board of DirectorsGeneral in the 2007

Proxy Statement.





Item 14 - Principal Accountant Fees and Services



Information regarding principal accountant fees and services is incorporated by reference from the section entitled Audit Firm Fee Summary in the 2007 Proxy Statement.







75



---





Item 15  Exhibits, Financial Statement Schedules .





(a)(1)

Financial Statements.  The following financial statements and supplementary data are included in Item 8 of Part II of this Annual Report on Form 10-K.



|                                                                                                     |               
|---------------------------------------------------------------------------------------------------- | --------------
|Financial Statements                                                                                 | Form 10-K Page
|Report of Independent Registered Public Accounting Firm, Dixon Hughes PLLC, dated March 15, 2007     | 40            
|Consolidated Balance Sheets as of December 31, 2006 and 2005                                         | 41            
|Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004           | 42            
|Consolidated Statements of Comprehensive Income for the years ended December 31, 2006, 2005 and 2004 | 43            
|Consolidated Statements of Shareholders Equity for the years ended December 31, 2006, 2005 and 2004 | 44            
|Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004           | 45            
|Notes to Consolidated Financial Statements                                                           | 46            



(a)(2)

Financial Statement Schedules.  All applicable financial statement schedules required under Regulation S-X have been included in the Notes to Consolidated Financial Statements.



(a)(3)

Exhibits. The following exhibits are filed as part of this Annual Report on Form 10-K.





|            |                                                                                                                                                                                                                                                                              
|----------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. | Description of Exhibit                                                                                                                                                                                                                                                       
|3.1         | Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004)                         
|3.2         | Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Companys Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)                                                                                                              
|4           | Specimen of Certificate for Four Oaks Fincorp, Common Stock (incorporated by reference to Exhibit 4 to the Companys Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)                                                                                      
|10.1        | Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)                                
|10.2        | Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)                    
|10.3        | Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)                        
|10.4        | Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)                
|10.5        | Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement)





76



---







|      |                                                                                                                                                                                                                                                                                                                     
|----- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.6  | Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement)                                     
|10.7  | Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement)                                                              
|10.8  | Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement)                                                       
|10.9  | Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.9 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                                                         
|10.10 | Severance Compensation Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.10 to the Companys Annual Report on form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                                                      
|10.11 | Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.11 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                                                             
|10.12 | Severance Compensation Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.12 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                                                           
|10.13 | Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)                                                              
|10.14 | Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)                                                                           
|10.15 | Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)                                                           
|10.16 | Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)                                                         
|10.17 | Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on January 25, 2006) (management contract or compensatory plan, contract or arrangement)                                                                    
|10.18 | Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on April 4, 2006)                                                                                    
|10.19 | Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed with the SEC on April 4, 2006)                                                                                                               
|10.20 | Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Companys Current Report on Form 8-K filed with the SEC on April 4, 2006)
|21    | Subsidiaries of Four Oaks Fincorp, Inc.                                                                                                                                                                                                                                                                             
|23    | Consent of Dixon Hughes PLLC                                                                                                                                                                                                                                                                                        
|31.1  | Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                        





77



---







|     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|31.2 | Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                
|32.1 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]  
|32.1 | Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]



(b) See (a)(3) above.



(c) See (a)(2) above.











78



---





SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



FOUR OAKS FINCORP, INC.



Date: March 15, 2007                                                 By:

/s/ Ayden R. Lee, Jr.

Ayden R. Lee, Jr.

Chairman, President and Chief Executive Officer



Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.



Date: March 15, 2007

/s/

Ayden R. Lee, Jr.

Ayden R. Lee, Jr.

Chairman, President and Chief Executive Officer

and Director



Date: March 15, 2007

/s/

Nancy S. Wise

Nancy S. Wise

Executive Vice President and Chief

Financial Officer



Date: March 15, 2007

/s/

William J. Edwards

William J. Edwards

Director



Date: March 15, 2007

/s/

Warren L. Grimes

Warren L. Grimes

Director



Date: March 15, 2007

/s/

Dr. R. Max Raynor, Jr.

Dr. R. Max Raynor, Jr.

Director



Date: March 15, 2007

/s/

Percy Y. Lee

Percy Y. Lee

Director



Date: March 15, 2007

/s/

Paula C. Bowman

Paula C. Bowman

Director



Date: March 15, 2007

/s/

William Ashley Turner

William Ashley Turner

Director





Date: March 15, 2007

/s/

Michael A. Weeks

Michael A. Weeks

Director





79



---











|            |                                                                                                                                                                                                                                                                                
|----------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. | Description of Exhibit                                                                                                                                                                                                                                                         
|3.1         | Articles of Incorporation of Four Oaks Fincorp, Inc. including Articles of Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004)                           
|3.2         | Bylaws of Four Oaks Fincorp, Inc. (incorporated by reference to Exhibit 3.2 to the Companys Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)                                                                                                                
|4           | Specimen of Certificate for Four Oaks Fincorp, Common Stock (incorporated by reference to Exhibit 4 to the Companys Current Report on Form 8-K12G3 filed with the SEC on July 2, 1997)                                                                                        
|10.1        | Employment Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)                                  
|10.2        | Severance Compensation Agreement with Ayden R. Lee, Jr. (incorporated by reference to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 1997) (management contract or compensatory plan, contract or arrangement)                      
|10.3        | Amended and Restated Nonqualified Stock Option Plan (incorporated by reference to Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)                          
|10.4        | Amended and Restated Employee Stock Purchase and Bonus Plan (incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 2004) (management contract or compensatory plan, contract or arrangement)                  
|10.5        | Second Amended and Restated Dividend Reinvestment and Stock Purchase Plan (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on December 21, 2006) (management contract or compensatory plan, contract or arrangement)  
|10.6        | Four Oaks Bank & Trust Company Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 1998) (management contract or compensatory plan, contract or arrangement)
|10.7        | Employment Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.7 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001) (management contract or compensatory plan, contract or arrangement)                         
|10.8        | Severance Compensation Agreement with Clifton L. Painter (incorporated by reference to Exhibit 10.8 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2002) (management contract or compensatory plan, contract or arrangement)                  
|10.9        | Executive Employment Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.9 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                    
|10.10       | Severance Compensation Agreement with W. Leon Hiatt, III (incorporated by reference to Exhibit 10.10 to the Companys Annual Report on form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                 
|10.11       | Executive Employment Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.11 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                        
|10.12       | Severance Compensation Agreement with Nancy S. Wise (incorporated by reference to Exhibit 10.12 to the Companys Annual Report on Form 10-KSB for the period ended December 31, 2003) (management contract or compensatory plan, contract or arrangement)                      
|10.13       | Form of Stock Option Agreement (Non-Employee Director) (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)                         



80





---







|      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|----- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.14 | Form of Stock Option Agreement (Employee) (incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed with the SEC on March 1, 2005) (management contract or compensatory plan, contract or arrangement)                                                                                                                                                                                                                                                                                                   
|10.15 | Executive Employment Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.15 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)                                                                                                                                                                                                                                                                                   
|10.16 | Severance Compensation Agreement with Jeff D. Pope (incorporated by reference to Exhibit 10.16 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004) (management contract or compensatory plan, contract or arrangement)                                                                                                                                                                                                                                                                                 
|10.17 | Summary of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on January 25, 2006) (management contract or compensatory plan, contract or arrangement)                                                                                                                                                                                                                                                                                            
|10.18 | Amended and Restated Declaration of Trust of Four Oaks Statutory Trust I, dated as of March 30, 2006 (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on April 4, 2006)                                                                                                                                                                                                                                                                                                            
|10.19 | Guarantee Agreement of Four Oaks Fincorp, Inc. dated as of March 30, 2006 (incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form 8-K filed with the SEC on April 4, 2006)                                                                                                                                                                                                                                                                                                                                       
|10.20 | Indenture, dated as of March 30, 2006 by and between Four Oaks Fincorp, Inc. and Wilmington Trust Company, as Trustee, relating to Junior Subordinated Debt Securities due June 15, 2036 (incorporated by reference to Exhibit 10.3 to the Companys Current Report on Form 8-K filed with the SEC on April 4, 2006)                                                                                                                                                                                                                        
|21    | Subsidiaries of Four Oaks Fincorp, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|23    | Consent of Dixon Hughes PLLC                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|31.1  | Certification of Chief Executive Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                
|31.2  | Certification of Chief Financial Officer Pursuant to Rule 13a-14/15d-14 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                
|32.1  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]  
|32.1  | Certification of Chief Financial Officer to Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 905 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that Act, be deemed to be incorporated by reference into any document or filed herewith for the purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]







81