FOFN 06.30.2013 10Q

10-Q 1 fofn0630201310q.htm 10-Q FOFN 06.30.2013 10Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2013

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		(IRS Employer
incorporation or organization)		Identification Number)

6114 U.S. 301 SOUTH, FOUR OAKS, NC 27524

(Address of principal executive office, including zip code)

(919) 963-2177

(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files) xYES oNO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer o	Accelerated filer o
Non-accelerated filer o (Do not check if a smaller reporting company)	Smaller reporting company x

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

oYES xNO

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:



Common Stock,	7,940,718
par value $1.00 per share	(Number of shares outstanding
(Title of Class)	as of August 8, 2013)

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TABLE OF CONTENTS		Page No.

Part I.	FINANCIAL INFORMATION

Item 1 -	Financial Statements

	Consolidated Balance Sheets
	June 30, 2013 (Unaudited) and December 31, 2012	3

	Consolidated Statements of Operations (Unaudited)
	Three and Six Months Ended June 30, 2013 and 2012	4

	Consolidated Statements of Comprehensive Income (Unaudited)
	Three and Six Months Ended June 30, 2013 and 2012	5

	Consolidated Statement of Shareholders’ Equity (Unaudited)
	Six Months Ended June 30, 2013 and 2012	6

	Consolidated Statements of Cash Flows (Unaudited)
	Six Months Ended June 30, 2013 and 2012	7

	Notes to Consolidated Financial Statements (Unaudited)	8

Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	40

Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	50

Item 4 -	Controls and Procedures	50

Part II.	OTHER INFORMATION

Item 1 -	Legal Proceedings	51

Item 1A-	Risk Factors	51

Item 6 -	Exhibits	52

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Part I. FINANCIAL INFORMATION

Item 1 – FINANCIAL STATEMENTS

FOUR OAKS FINCORP, INC.

CONSOLIDATED BALANCE SHEETS



	June 30, 2013			December 31,
	(Unaudited)			2012^(*)
	(amounts in thousands, except share data)
ASSETS
Cash and due from banks	$	14,319		$	18,862
Interest-earning deposits	145,567			164,288
Cash and cash equivalents	159,886			183,150
CDs held for investment	30,135			26,460
Investment securities available for sale, at fair value	5,850			73,722
Investment securities held to maturity, at amortized cost	105,319			20,329
Total investment securities	111,169			94,051
Loans held for sale	1,016			19,297
Loans	489,238			497,929
Allowance for loan losses	(14,038		)	(16,549		)
Net loans	475,200			481,380
Accrued interest receivable	1,523			1,869
Bank premises and equipment held for sale, net	—			1,901
Bank premises and equipment, net	13,051			13,382
FHLB stock	6,076			6,415
Investment in life insurance	14,275			14,139
Foreclosed assets	11,776			15,136
Other assets	4,823			8,318
Total assets	$	828,930		$	865,498
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand	$	205,937		$	189,048
Money market, NOW accounts and savings accounts	169,019			164,614
Time deposits, $100,000 and over	174,513			215,984
Other time deposits	108,012			130,210
Total deposits	657,481			699,856
Borrowings	112,000			112,000
Subordinated debentures	12,372			12,372
Subordinated promissory notes	12,000			12,000
Accrued interest payable	1,574			1,736
Other liabilities	11,239			4,858
Total liabilities	806,666			842,822
Commitments (Note B)
Shareholders’ equity:
Common stock, $1.00 par value, 20,000,000 shares authorized; 7,940,718 shares issued and outstanding at June 30, 2013 and 7,815,315 shares issued and outstanding at December 31, 2012	7,941			7,815
Additional paid-in capital	34,254			34,192
Accumulated deficit	(20,067		)	(20,040		)
Accumulated other comprehensive income	136			709
Total shareholders' equity	22,264			22,676
Total liabilities and shareholders' equity	$	828,930		$	865,498

(*) Derived from audited consolidated financial statements.

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

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FOUR OAKS FINCORP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)



	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
	(amounts in thousands, except share data)
Interest and dividend income:
Loans, including fees	$	6,785		$	7,855		$	13,781		$	16,327
Investment securities:
Taxable	226			473			475			967
Dividends	86			88			185			155
Interest-earning deposits and Federal funds sold	166			165			334			297
Total interest and dividend income	7,263			8,581			14,775			17,746
Interest expense:
Deposits	897			1,838			1,847			3,735
Borrowings	1,014			1,013			2,016			2,027
Subordinated debentures	51			57			102			116
Subordinated promissory notes	254			258			506			516
Total interest expense	2,216			3,166			4,471			6,394
Net interest income	5,047			5,415			10,304			11,352
Provision for loan losses	—			(39		)	35			(286		)
Net interest income after provision for loan losses	5,047			5,454			10,269			11,638
Non-interest income:
Service charges on deposit accounts	410			463			875			932
Other service charges, commissions and fees	845			693			1,630			1,301
Gains on sale of investment securities available for sale	321			645			370			657
Total other-than-temporary impairment loss	—			2			—			64
Portion of loss recognized in other comprehensive income	—			(2		)	—			(64		)
Net impairment loss recognized in earnings	—			—			—			—
Income from investment in life insurance	68			83			137			168
Other non-interest income	37			120			778			120
Total non-interest income	1,681			2,004			3,790			3,178
Non-interest expenses:
Salaries	2,531			2,553			5,314			5,092
Employee benefits	464			477			1,000			988
Occupancy expenses	306			328			653			660
Equipment expenses	342			381			705			768
Professional and consulting fees	703			743			1,406			1,293
FDIC assessments	478			577			919			1,118
Foreclosed asset-related costs, net	346			735			940			1,093
Collection expenses	334			526			691			998
Other	1,328			1,284			2,458			2,400
Total non-interest expenses	6,832			7,604			14,086			14,410
Income (loss) before income taxes	(104		)	(146		)	(27		)	406
Provision for income taxes	—			(175		)	—			(175		)
Net Income (loss)	$	(104	)	$	29		$	(27	)	$	581
Basic net income (loss) per common share	$	(0.01	)	$	—		$	—		$	0.08
Diluted net income (loss) per common share	$	(0.01	)	$	—		$	—		$	0.08
Weighted Average Shares Outstanding, Basic	7,924,509			7,750,292			7,873,330			7,709,055
Weighted Average Shares Outstanding, Diluted	7,924,509			7,750,292			7,873,330			7,709,055

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

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FOUR OAKS FINCORP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)



	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
	(amounts in thousands)
Net income (loss)	$	(104	)	$	29		$	(27	)	$	581

Other comprehensive income (loss):
Securities available for sale:
Unrealized gains(losses) on securities held for sale	(529		)	634			(573		)	1,035
Tax benefit(expense)	204			(244		)	221			(405		)
Reclassification of gains recognized in net income	(321		)	(645		)	(370		)	(657		)
Tax benefit	124			249			143			253
Amortization of unrealized gains on investment securities transferred from available-for-sale to held-to-maturity	10			—			10			—
Tax expense	(4		)	—			(4		)	—
Portion of other-than-temporary loss recognized in other comprehensive income	—			(2		)	—			(64		)
Tax benefit	—			2			—			26
Total other comprehensive income (loss)	(516		)	(6		)	(573		)	188

Comprehensive income (loss)	$	(620	)	$	23		$	(600	)	$	769

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

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FOUR OAKS FINCORP, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (UNAUDITED)



	Common stock			Additional paid-in capital		Accumulated deficit			Accumulated other comprehensive income		Total shareholders' equity
	Shares	Amount		Additional paid-in capital		Accumulated deficit			Accumulated other comprehensive income		Total shareholders' equity
	(amounts in thousands, except share data)
BALANCE, DECEMBER 31, 2011	7,663,387	$	7,663	$	34,048	$	(13,071	)	$	1,052	$	29,692
Net income						581					581
Other comprehensive income									188		188
Issuance of common stock	102,860	103		60							163
Stock based compensation				34							34
BALANCE, JUNE 30, 2012	7,766,247	$	7,766	$	34,142	$	(12,490	)	$	1,240	$	30,658



	Common stock			Additional paid-in capital		Accumulated deficit			Accumulated other comprehensive income			Total shareholders' equity
	Shares	Amount		Additional paid-in capital		Accumulated deficit			Accumulated other comprehensive income			Total shareholders' equity
	(amounts in thousands, except share data)
BALANCE, DECEMBER 31, 2012	7,815,385	$	7,815	$	34,192	$	(20,040	)	$	709		$	22,676
Net loss	—	—		—		(27		)	—			(27		)
Other comprehensive loss	—	—		—		—			(573		)	(573		)
Issuance of common stock	125,333	126		42		—			—			168
Stock based compensation	—	—		20		—			—			20
BALANCE, JUNE 30, 2013	7,940,718	$	7,941	$	34,254	$	(20,067	)	$	136		$	22,264

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

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FOUR OAKS FINCORP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)



	Six Months Ended
	June 30,
	2013			2012
	(amounts in thousands)
Cash flows from operating activities:
Net income	$	(27	)	$	581
Adjustments to reconcile net income to net cash provided by operations:
Provision for loan losses	35			(286		)
Provision for depreciation and amortization	499			592
Net amortization of bond premiums and discounts	913			946
Stock based compensation	20			34
Gain on sale of investment securities	(370		)	(657		)
Gain on sale of branches	(586		)	—
Loss on sale of foreclosed assets, net	51			113
Valuation adjustment on foreclosed assets	637			980
Earnings on bank-owned life insurance	(137		)	(168		)
Gain on sale of mortgage loans held for sale	(324		)
Originations of mortgage loans held for sale	(15,789		)	—
Proceeds from sale of mortgage loans held for sale	15,695
Changes in assets and liabilities:
Other assets	3,477			1,667
Accrued interest receivable	346			253
Other liabilities	6,381			811
Accrued interest payable	(162		)	197
Net cash provided by operating activities	10,659			5,063
Cash flows from investing activities:
Proceeds from sales and calls of investment securities available for sale	12,879			27,245
Proceeds from paydowns of investment securities available for sale	5,273			6,130
Proceeds from paydowns of investment securities held to maturity	3,903			2,368
Purchases of investment securities available for sale	(17,863		)	(27,886		)
Purchases of investment securities held to maturity	(22,626		)	(5,319		)
Net cash from sale of branches	(39,622		)	—
Purchases of CDs held for investment	(3,675		)	—
Redemption of FHLB stock	339			107
Net decrease in loans outstanding	8,663			39,432
Purchase of bank premises and equipment	(142		)	(279		)
Proceeds from sales of foreclosed assets	3,781			2,430
Net recoveries (expenditures) on foreclosed assets	12			(21		)
Net cash (used in) provided by investing activities	(49,078		)	44,207
Cash flows from financing activities:
Net (decrease) increase in deposit accounts	14,986			(14,432		)
Proceeds from issuance of common stock	169			163
Net cash (used in) provided by financing activities	15,155			(14,269		)
Net (decrease) increase in cash and cash equivalents	(23,264		)	35,001
Cash and cash equivalents at beginning of period	183,150			164,966
Cash and cash equivalents at end of period	$	159,886		$	199,967

Supplemental disclosures of cash flow information:
Interest paid on deposits and borrowings	$	(4,633	)	$	(6,197	)
Supplemental disclosure for sale of branches:
Proceeds from sale of fixed assets	$	1,867		$	—
Proceeds from sale of loans	$	15,060		$	—
Assumption of customer deposits	$	(57,361	)	$	—
Gain on sale of branches	$	586		$	—
Proceeds from sale of other assets	$	225		$	—
Supplemental disclosures of noncash investing and financing activities:
Unrealized (losses) gains on investment securities available for sale, net of taxes	$	(928	)	$	188
Unrealized gains on investment securities transferred from available-for-sale to held-to-maturity	$	355		$	—
Transfers of loans to foreclosed assets	$	1,121		$	6,636
Loans transferred to held for investment from held for sale	$	3,639		$	—
Bank premise and equipment transferred from held for sale	$	34		$	—
Available-for-sale securities purchased, not yet settled	$	4,708		$	—
Transferred from AFS to HTM securities	$	76,487		$	—

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

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements

NOTE A - ORGANIZATION AND GOING CONCERN CONSIDERATIONS

Basis of Presentation

In management’s opinion, the financial information contained in the accompanying unaudited consolidated financial statements reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of and for the three and six months ended June 30, 2013 and 2012, in conformity with accounting principles generally accepted in the United States of America. The consolidated financial statements include the accounts and transactions of Four Oaks Fincorp, Inc., a bank holding company incorporated under the laws of the State of North Carolina (the “Company”), and its wholly-owned subsidiary, Four Oaks Bank & Trust Company (the “Bank”). Operating results for the three and six months ended June 30, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2013. As of October 19, 2012 Four Oaks Mortgage Services, LLC ceased its mortgage origination operations and the related partnership agreement with PrimeLending was terminated as of that date. All mortgage originations are now conducted by the

Bank.

The organization and business of the Company, accounting policies followed by the Company and other information are contained in the notes to the consolidated financial statements filed as part of the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. This Quarterly Report should be read in conjunction with such Annual Report.

Certain amounts previously presented in our Consolidated Financial Statements for the prior periods have been reclassified to conform to current classifications. All such reclassifications had no impact on the prior periods' Statements of Operations, Comprehensive Income (Loss), or Shareholders' Equity as previously reported.

Going Concern Considerations

The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. Improving loan trends account for the small provision for loan losses for the three and six months ended June 30, 2013 and the negative provision for the six months ended June 30, 2012. The second half of 2012 saw increases in loan charge offs and writedowns of foreclosed assets due to initiatives by the Special Assets department which was developed to work with nonperforming assets to either return them to performing status or to remove them from the Company's books. Management expects some losses to result from this team's efforts as the process for moving these assets accelerates. Management still believes that its current operations and its cash availability are sufficient for the Company to discharge its liabilities and meet its commitments in the normal course of business. While management does not anticipate further significant deterioration in the Bank's loan portfolio and has performed stress tests and financial modeling under various potential scenarios in determining that the Company and the Bank will maintain at least adequate capitalization under federal regulatory guidelines, no assurances regarding these expectations can be made. These consolidated financial statements do not include any adjustments relating to the recoverability or classification of assets or the amounts and classification of liabilities that may be necessary should the Company be unable to continue as a going concern.

Net loss for the six months ended June 30, 2013 was $27,000 compared to a net income of $581,000 for the same period of 2012. In comparing the six months ended June 30, 2013 and 2012, there was a slight increase in the provision for loan losses of $321,000. A slight increase in net charge-offs led to a loan loss provision in the amount of $35,000 for the six months ended June 30, 2013 compared to a negative provision for loan losses of $286,000 for the same period in 2012. Net charge offs for the first six months of 2013 were $2.5 million and $2.4 million for the comparable period in 2012. The historically low level of provision is attributed to improvement in problem loans and in credit oversight processes, as well as fewer loans outstanding.

At June 30, 2013 the Company’s total capital to risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to average assets were 10.82%, 6.38%, and 3.68%, respectively, compared to 10.17%, 5.93% and 3.33%, respectively, at December 31, 2012. At June 30, 2013, the Bank’s total capital to risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to average assets were 10.95%, 9.68% and 5.58%, respectively, compared to 10.20%, 8.93%, and 5.01%, respectively, at December 31, 2012.

The Company and the Bank entered into a formal written agreement (the “Written Agreement”) with the Federal Reserve Bank of Richmond (“FRB”) and the North Carolina Office of the Commissioner of Banks (“NCCOB”) that imposes certain restrictions on the Company and the Bank, as described in Notes I, Subordinated Notes and J, Regulatory Restrictions. A material failure to

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

comply with the Written Agreement’s terms could subject the Company to additional regulatory actions and further restrictions on its business, which may have a material adverse effect on the Company’s future results of operations and financial condition.

In order for the Company and the Bank to remain well capitalized under federal banking agencies’ guidelines, management believes that the Company will need to raise additional capital to absorb the potential future credit losses associated with the disposition of its nonperforming assets. On July 19, 2013, the Company amended its Articles of Incorporation to increase the number of authorized shares of common stock of the Company from 20,000,000 to 80,000,000. This amendment was approved by the Company's shareholders on June 3, 2013. Management continues to evaluate various alternatives to increase tangible common equity and regulatory capital through the issuance of additional equity. The Company is actively managing its balance sheet to preserve capital and to improve capital ratios and actively evaluating a number of capital sources, asset reductions and other balance sheet management strategies to ensure that the projected level of regulatory capital can support its balance sheet long-term. There can be no assurance as to whether these efforts will be successful, either on a short-term or long-term basis. Should these efforts be unsuccessful, the Company may be unable to discharge its liabilities in the normal course of business. There can be no assurance that the Company will be successful in any efforts to raise additional capital.

Cash and cash equivalents at June 30, 2013 were approximately $159.9 million, of which approximately $4.7 million has been earmarked for scheduled broker deposit maturities over the remainder of 2013, excluding CDARS maturities which are scheduled to renew. Based on our liquidity analysis, management anticipates that the Company will be able to meet its future obligations as they become due. If unanticipated market factors emerge, or if the Company is not successful in its efforts to comply with the requirements set forth in the Written Agreement, the FRB and/or the NCCOB may take further enforcement or other actions. These actions might include greater restrictions on the Company’s operations, a revocation of its charter and the placement of the Bank into receivership if the situation materially deteriorates. At this time the Company is in partial compliance with the provisions of the Written Agreement.

NOTE B - COMMITMENTS AND CONTIGENCIES

The following table presents loan commitments at June 30, 2013.



	June 30, 2013
	(amounts in thousands)
Commitments to extend credit	$	31,769
Undisbursed lines of credit	18,330
Financial stand-by letters of credit	348
Performance stand-by letters of credit	2,191
Legally binding commitments	52,638

Unused credit card lines	13,593

Total	$	66,231

On May 20, 2013, the U.S. Department of Justice issued a subpoena to the Bank requiring the production of documents in connection with an investigation of consumer fraud related to third party payment processing. The Bank is cooperating with the government's request and is in the process of responding to the subpoena. The Company is unable to predict how long this investigation will continue or whether it will result in any adverse action.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

NOTE C - NET INCOME PER SHARE

Basic net income (loss) per share represents earnings credited to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options.

Basic and diluted net income (loss) per common share have been computed based upon net income (loss) 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:



	Three Months Ended		Six Months Ended
	June 30,		June 30,
	2013	2012	2013	2012
Weighted average number of common shares used in computing basic net income per common share	7,924,509	7,750,292	7,873,330	7,709,055
Effect of dilutive stock options	—	—	—	—
Weighted average number of common shares and dilutive potential common shares used in computing diluted net income(loss) per share	7,924,509	7,750,292	7,873,330	7,709,055

For the three and six months ended June 30, 2013, the stock options are anti-dilutive due to losses incurred.

For the three and six month period ended June 30, 2012 all stock options were considered anti-dilutive either as a result of net losses incurred or the average market price for the shares during each period was less than the assumed proceeds that would be received by the Company upon exercise of the options.

For the periods ended June 30, 2013 and 2012, there were 305,005 and 281,444 anti-dilutive stock options outstanding, respectively, which represented all of the options outstanding for both periods.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

NOTE D– INVESTMENT SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses, and fair values of securities available for sale and securities held to maturity as of June 30, 2013 and December 31, 2012 are as follows:



	June 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Available for Sale:	(amounts in thousands)
Taxable municipal securities	$	1,521	$	—	$	—	$	1,521
Mortgage-backed securities
GNMA	3,187		—		—		3,187
Trust preferred securities	1,175		—		156		1,019
Equity securities	97		26		—		123
Total	$	5,980	$	26	$	156	$	5,850



	June 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Held to Maturity:	(amounts in thousands)
Taxable municipal securities	$	3,660	$	175	$	—	$	3,835
Mortgage-backed securities
GNMA	96,561		456		1,593		95,424
FNMA	5,098		—		16		5,082
Total	$	105,319	$	631	$	1,609	$	104,341



	December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Available for Sale:	(amounts in thousands)
Taxable municipal securities	$	5,459	$	454	$	—	$	5,913
Mortgage-backed securities
GNMA	60,056		704		17		60,743
FNMA	5,872		10		2		5,880
Trust preferred securities	1,175		—		169		1,006
Equity securities	170		11		1		180
Total	$	72,732	$	1,179	$	189	$	73,722



	December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Held to Maturity:	(amounts in thousands)
Mortgage-backed securities - GNMA	$	20,329	$	339	$	—	$	20,668
Total	$	20,329	$	339	$	—	$	20,668

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

During the second quarter of 2013, the Company transferred $76.5 million of available-for-sale state and municipal debt securities to the held-to-maturity category, reflecting the Company's intent to hold those securities to maturity. Transfers of investment securities into the held-to-maturity category from the available-for-sale category are made at fair value at the date of transfer. The related $.4 million of unrealized holding gains that were included in the transfer is retained in accumulated other comprehensive income and in the carrying value of the held-to-maturity securities. This amount will be amortized as an adjustment to interest income over the remaining life of the securities. This will offset the impact of amortization of the net premium created in the transfer. There were no gains or losses recognized as a result of this transfer.

The following tables show 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 June 30, 2013 and December 31, 2012. At December 31, 2012 there were no unrealized losses in the held to maturity category.



	June 30, 2013
	Less Than 12 Months				12 Months or More				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
	(amounts in thousands)
Securities Available for Sale:
Other than temporary impairment
Trust preferred securities	$	—	$	—	$	1,019	$	156	$	1,019	$	156
Total other than temporarily impaired securities	$	—	$	—	$	1,019	$	156	$	1,019	$	156



	June 30, 2013
	Less Than 12 Months				12 Months or More				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
	(amounts in thousands)
Securities Held to Maturity:
Mortgage-backed securities
GNMA	$	55,977	$	1,593	$	—	$	—	$	55,977	$	1,593
FNMA	5,081		16		—		—		5,081		16
Total temporarily impaired securities	$	61,058	$	1,609	$	—	$	—	$	61,058	$	1,609



	December 31, 2012
	Less Than 12 Months				12 Months or More				Total
	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
	(amounts in thousands)
Securities Available for Sale:
Mortgage-backed securities
GNMA	$	5,132	$	17	$	—	$	—	$	5,132	$	17
FNMA	1,998		2		—		—		1,998		2
Total temporarily impaired securities	$	7,130	$	19	$	—	$	—	$	7,130	$	19

Other than temporary impairment
Trust preferred securities	$	—	$	—	$	1,006	$	169	$	1,006	$	169
Total other than temporarily impaired securities	$	—	$	—	$	1,006	$	169	$	1,006	$	169

-12-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Management evaluates each quarter whether unrealized losses on securities represent impairment that is other than temporary. For debt securities, the Company considers its intent to sell the securities or if it is more likely than not that the Company will be required to sell the securities. If such impairment is identified, based upon the intent to sell or the more likely than not threshold, the carrying amount of the security is reduced to fair value with a charge to earnings. Upon the result of the aforementioned review, management then reviews for potential other than temporary impairment based upon other qualitative factors. In making this evaluation, management considers changes in market rates relative to those available when the security was acquired, changes in market expectations about the timing of cash flows from securities that can be prepaid, performance of the debt security, and changes in the market's perception of the issuer's financial health and the security's credit quality. If determined that a debt security has incurred other than temporary impairment, then the amount of the credit related impairment is determined. If a credit loss is evident, the amount of the credit loss is charged to earnings and the non-credit related impairment is recognized through other comprehensive income.

At June 30, 2013, the unrealized losses relate to 27 mortgage backed securities and two trust preferred securities. Only the two trust preferred securities were in a continuous unrealized loss position for more than twelve months. At December 31, 2012 management determined that one of the trust preferred securities was other than temporarily impaired in the amount of $75,000. Management continues to monitor the creditworthiness of the issuer's of the trust preferred securities and has determined that based on the their current financial condition the unrealized loss as of June 30, 2013 are not credit related and will therefore be recognized in other comprehensive income. The gross unrealized losses reported for mortgage-backed securities relate to investment securities issued by the Federal National Mortgage Association and the Government National Mortgage Association. The unrealized losses were primarily attributable to changes in interest rates and not due to the credit quality of the investment securities. The Company does not intend to sell, and it is not more likely than not that the Company will be required to sell, these debt securities before the anticipated recovery of the amortized cost basis and; therefore, does not consider them to be other-than-temporarily impaired at June 30, 2013.

-13-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The amortized cost and fair value of available for sale, and held to maturity securities at June 30, 2013 by contractual maturities are shown on the following table. 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.



	Available for Sale
	Amortized Cost		Fair Value
	(amounts in thousands)
Taxable municipal securities:
Due after one year through five years	$	—	$	—
Due after five years through ten years	1,521		1,521
Due after ten years	—		—
Total taxable municipal securities	1,521		1,521

Mortgage-backed securities - GNMA/FNMA:
Due within one year	—		—
Due after one year through five years	3,187		3,187
Due after five years through ten years	—		—
Due after ten years	—		—
Total mortgage-backed securities - GNMA/FNMA	3,187		3,187

Other securities:
Trust preferred securities	1,175		1,019
Equity securities	97		123
Total other securities	1,272		1,142

Total available for sale securities	$	5,980	$	5,850

	Held to Maturity
	Amortized Cost		Fair Value
	(amounts in thousands)
Taxable municipal securities:
Due within one year	—		—
Due after one year through five years	257		265
Due after five years through ten years	3,403		3,570
Due after ten years	—		—
Total taxable municipal securities	3,660		3,835

Mortgage-backed securities - GNMA/FNMA:
Due within one year	1,432		1,468
Due after one year through five years	68,690		68,536
Due after five years through ten years	30,326		29,304
Due after ten years	1,211		1,198
Total mortgage-backed securities - GNMA/FNMA	101,659		100,506

Total held to maturity securities	$	105,319	$	104,341

Securities with a carrying value of approximately $104.3 million and $93.2 million at June 30, 2013 and December 31, 2012, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.

Proceeds from sales and calls of investment securities available for sale for the six months ended June 30, 2013 and 2012 were $12.9 million and $27.2 million, respectively. Sales and calls of securities available for sale and equity securities for the six months ended June 30, 2013 and 2012 generated gross realized gains of $369,792 and $656,540, and gross losses of $0, respectively.

-14-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Sales and calls of securities available for sale and equity securities during the three months ended June 30, 2013 and 2012 were $10.7 million and $21.9 million, respectively. For the three months ended June 30, 2013 and 2012 generated gross realized gains were $321,120 and $645,002 and gross losses of $0, respectively.

-15-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

NOTE E – LOANS

The Company has adopted comprehensive lending policies, underwriting standards and loan review procedures, which are reviewed on a regular basis. Each class of loans detailed below is subject to risks that could have an adverse impact on the credit quality of the loan portfolio. Loans are primarily made in the Company's market area in North Carolina, principally Johnston County, and parts of Wake, Harnett, Duplin, and Sampson counties.

Commercial and industrial loans

Each commercial loan or lease is underwritten based primarily upon the customer's ability to generate the required cash flow to service the debt in accordance with the contractual terms and conditions of the loan agreement. A complete understanding of the borrower's businesses, including the experience and background of the principals, is obtained prior to approval. To the extent that the loan or lease is secured by collateral, the likely value of the collateral and what level of strength the collateral brings to the transaction is evaluated. This collateral is generally comprised of personal property or business assets, such as inventory or accounts receivable. To the extent that the principals or other parties provide personal guarantees, the relative financial strength and liquidity of each guarantor is assessed. Common risks include general economic conditions within the markets the Bank serves, as well as risks that are specific to each transaction, including operational performance of the business, collectability of receivables, demand for products and services, personal events such as disability or change in marital status, and reductions in the value of collateral.

Commercial construction and land development loans

Commercial construction and land development loans are fully underwritten based on the borrower's repayment capacity and experience, as well as the project's structure, market, and financial feasibility. All debts and sources of income are analyzed prior to commitment. These loans are highly dependent on the supply and demand for commercial real estate and developed lots in the markets served by the Bank. Deterioration in demand could result in significant decreases in the underlying collateral values and make repayment of the outstanding loans more difficult for customers.

Commercial real estate loans

Commercial real estate loans consist primarily of loans secured by nonresidential owner or non-owner occupied real estate, multifamily housing, and agricultural loans. Owner-occupied commercial properties are real estate properties whose loan repayment capacities are based on the credit strength and cash flow of the business occupying and operating the property. Non-owner occupied and multifamily commercial real estate are primarily dependent on successful operation or management of the property. The primary risk associated with these loans is the ability of the income-producing property to collateralize the loan to produce adequate cash flow to service the debt. High unemployment or generally weak economic conditions may result in customers having to provide rental rate concessions to achieve adequate occupancy rates. While commercial real estate loans are normally secured by commercial buildings for office, storage and warehouse space, it is possible that the liquidation of the collateral will not fully satisfy the obligation.

Residential construction loans

Residential construction loans are made to both individuals and builders/contractors and are typically secured by 1-4 family residential property. The Bank has stringent underwriting and initial investment requirements for new residential construction loans. The primary source of repayment on these loans comes from funds due to the sale of the underlying property or from permanent financing obtained by the individual building the residence. Significant and rapid declines in real estate values or demand can result in increased difficulty in selling these properties and/or converting these construction loans to permanent loans. Such a decline in values has led to unprecedented levels of foreclosures and losses within the banking industry. In addition, there has been an increase in the average time houses are on the market for sale.

Residential mortgage loans

Each residential mortgage loan is underwritten by performing an analysis of the borrower's cash flow, as well as reviewing credit reports for items such as payment history, credit utilization, length of credit history, types of credit currently in use, and recent credit inquiries. Since these loans are secured by collateral, the likely value of that collateral is evaluated. Common risks to these loans that are not specific to individual transactions include general economic conditions within the markets the Bank serves, particularly unemployment and potential declines in real estate values. Personal events such as disability or change in marital status also add risk to residential mortgage loans. Revolving mortgage loans are often secured by second liens on residential real estate, thereby making such loans particularly susceptible to declining collateral values. A substantial decline in collateral value

-16-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

could render a second lien position to be effectively unsecured. Additional risks include lien perfection inaccuracies and disputes with first lien holders that may further weaken the collateral position. Further, the open-end structure of these loans creates the risk that customers may draw on the lines in excess of the collateral value if there have been significant declines since origination.

Consumer and other loans

Consumer and other loans include loans secured by personal property such as automobiles, marketable securities, other titled recreational vehicles, including boats and motorcycles, as well as unsecured consumer debt. The value of underlying collateral within this class is especially volatile due to potential rapid depreciation in values since date of loan origination in excess of principal repayment. Consumer loan collections are sensitive to job loss, illness and other personal factors.

The classification of loans as of June 30, 2013 and December 31, 2012 are summarized as follows:



	June 30, 2013			December 31, 2012
	(amounts in thousands)
Commercial and industrial loans	$	27,701		$	29,563
Commercial construction and land development	79,362			90,899
Commercial real estate	186,324			181,194
Residential construction	24,263			20,445
Residential mortgage	161,806			165,009
Consumer	9,207			9,664
Other	907			1,278
Gross loans	489,570			498,052
Less:
Net deferred loan fees	(332		)	(123		)
Net loans before allowance	489,238			497,929
Allowance for loan losses	(14,038		)	(16,549		)

Total net loans	$	475,200		$	481,380

Nonperforming assets at June 30, 2013 and December 31, 2012 consist of the following:



	June 30, 2013		December 31, 2012
	(amounts in thousands)
Loans past due ninety days or more and still accruing	$	27	$	32
Nonaccrual loans	33,959		35,970
Foreclosed assets	11,776		15,136
Total	$	45,762	$	51,138

-17-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of an amount adequate to provide for known and inherent losses in the loan portfolio in the normal course of business. Management evaluates the adequacy of this allowance at least quarterly during which time those loans that are identified as impaired are evaluated individually.

The following tables are an analysis of the allowance for loan losses by loan class, as of and for the three and six months ended June 30, 2013 and 2012 and as of and for the twelve months ended December 31, 2012.



	Three Months Ended
	June 30, 2013
				Real Estate
	Commercial and Industrial			Commercial Construction and Land Development			Commercial Real Estate			Residential Construction			Residential Mortgage			Consumer			Other		Totals
Allowances for loan losses:	(amounts in thousands)
Balance April 1, 2013	$	1,178		$	7,619		$	2,472		$	462		$	3,282		$	173		$	61	$	15,247

Provision for loan losses	(395		)	62			271			125			(133		)	39			31		—

Loans charged-off	(42		)	(1,198		)	(987		)	(138		)	(294		)	(73		)	—		(2,732		)
Recoveries	228			91			1,007			—			158			39			—		1,523
Net (charge-offs) recoveries	186			(1,107		)	20			(138		)	(136		)	(34		)	—		(1,209		)

Balance June 30, 2013	$	969		$	6,574		$	2,763		$	449		$	3,013		$	178		$	92	$	14,038

-18-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	Six Months Ended
	June 30, 2013
				Real Estate
	Commercial and Industrial			Commercial Construction and Land Development			Commercial Real Estate			Residential Construction			Residential Mortgage			Consumer			Other		Totals
Allowances for loan losses:	(amounts in thousands)
Balance January 1, 2013	$	1,185		$	7,251		$	2,961		$	423		$	4,471		$	188		$	70	$	16,549

Provision for loan losses	(407		)	1,003			19			164			(835		)	69			22		35

Loans charged-off	(60		)	(1,858		)	(1,225		)	(138		)	(904		)	(164		)	—		(4,349		)
Recoveries	251			178			1,008			—			281			85			—		1,803
Net (charge-offs) recoveries	191			(1,680		)	(217		)	(138		)	(623		)	(79		)	—		(2,546		)

Balance June 30, 2013	$	969		$	6,574		$	2,763		$	449		$	3,013		$	178		$	92	$	14,038

Ending Balance: individually evaluated for impairment	$	338		$	348		$	509		$	—		$	253		$	—		$	—	$	1,448

Ending Balance: collectively evaluated for impairment	$	631		$	6,226		$	2,254		$	449		$	2,760		$	178		$	92	$	12,590

Loans:
Ending balance	$	27,701		$	79,362		$	186,324		$	24,263		$	161,806		$	9,207		$	907	$	489,570
Less: ending Balance: individually evaluated for impairment	1,246			16,108			15,392			695			14,991			22			—		48,454
Ending balance: collectively evaluated for impairment	$	26,455		$	63,254		$	170,932		$	23,568		$	146,815		$	9,185		$	907	$	441,116



	Three Months Ended
	June 30, 2012
				Real Estate
	Commercial and Industrial			Commercial Construction and Land Development			Commercial Real Estate			Residential Construction			Residential Mortgage			Consumer			Other			Totals
	(amounts in thousands)
Allowances for loan losses:
Balance April 1, 2012	2,343			8,785			2,673			375			4,773			412			22			19,383

Provision for loan losses	(452		)	(273		)	645			61			(229		)	220			(11		)	(39		)

Loans charged-off	(191		)	(982		)	(146		)	(35		)	(127		)	(210		)	—			(1,691		)
Recoveries	86			480			118			—			21			60						765
Net (charge-offs) recoveries	(105		)	(502		)	(28		)	(35		)	(106		)	(150		)	—			(926		)

Balance June 30, 2012	$	1,786		$	8,010		$	3,290		$	401		$	4,438		$	482		$	11		$	18,418

-19-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	Six Months Ended
	June 30, 2012
				Real Estate
	Commercial and Industrial			Commercial Construction and Land Development			Commercial Real Estate			Residential Construction			Residential Mortgage			Consumer			Other			Totals
Allowances for loan losses:	(amounts in thousands)
Balance January 1, 2012	$	2,730		$	8,799		$	3,800		$	740		$	4,630		$	413		$	29		$	21,141

Provision for loan losses	(616		)	566			(202		)	(304		)	(20		)	308			(18		)	(286		)

Loans charged-off	(440		)	(2,155		)	(486		)	(35		)	(278		)	(330		)	—			(3,724		)
Recoveries	112			800			178			—			106			91			—			1,287
Net (charge-offs) recoveries	(328		)	(1,355		)	(308		)	(35		)	(172		)	(239		)	—			(2,437		)

Balance December 31, 2012	$	1,786		$	8,010		$	3,290		$	401		$	4,438		$	482		$	11		$	18,418

Ending Balance: individually evaluated for impairment	$	292		$	3,342		$	1,609		$	105		$	2,421		$	—		$	—		$	7,769

Ending Balance: collectively evaluated for impairment	$	1,494		$	4,668		$	1,681		$	296		$	2,017		$	482		$	11		$	10,649
Loans:
Ending balance	$	33,588		$	108,015		$	189,624		$	24,493		$	185,272		$	10,341		$	2,457		$	553,790
Less ending balance: individually evaluated for impairment	1,502			35,505			24,171			1,176			24,083			64			—			86,501
Ending balance: collectively evaluated for impairment	$	32,086		$	72,510		$	165,453		$	23,317		$	161,189		$	10,277		$	2,457		$	467,289

-20-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	Twelve Months Ended
	December 31, 2012
				Real Estate
	Commercial and Industrial			Commercial Construction and Land Development			Commercial Real Estate			Residential Construction			Residential Mortgage			Consumer			Other		Totals
	(amounts in thousands)
Allowances for loan losses:
Balance January 1, 2012	$	2,730		$	8,799		$	3,800		$	740		$	4,630		$	413		$	29	$	21,141

Provision for loan losses	(1,464		)	5,205			2,486			(214		)	1,184			143			41		7,381

Loans charged-off	(703		)	(7,929		)	(3,691		)	(103		)	(1,801		)	(516		)	—		(14,743		)
Recoveries	622			1,176			366			—			458			148			—		2,770
Net (charge-offs) recoveries	(81		)	(6,753		)	(3,325		)	(103		)	(1,343		)	(368		)	—		(11,973		)

Balance December 31, 2012	$	1,185		$	7,251		$	2,961		$	423		$	4,471		$	188		$	70	$	16,549

Ending Balance: individually evaluated for impairment	$	636		$	1,693		$	640		$	86		$	2,334		$	—		$	—	$	5,389

Ending Balance: collectively evaluated for impairment	$	549		$	5,558		$	2,321		$	337		$	2,137		$	188		$	70	$	11,160

Loans:
Ending balance	$	29,563		$	90,899		$	181,194		$	20,445		$	165,009		$	9,664		$	1,278	$	498,052
Less: ending Balance: individually evaluated for impairment	1,437			20,885			17,742			1,173			17,573			50			—		58,860
Ending balance: collectively evaluated for impairment	$	28,126		$	70,014		$	163,452		$	19,272		$	147,436		$	9,614		$	1,278	$	439,192

Credit Quality Indicators

The Company uses an internal grading system to assign the degree of inherent risk on each individual loan. The grade is initially assigned by the lending officer and reviewed by the loan administration function throughout the life of the loan. The credit grades have been defined as follows:


•	Grade 1 - Lowest Risk

Loans secured by properly margined liquid collateral such as certificates of deposit, government securities, cash value of life insurance, stock actively traded on one of the major stock exchanges, etc. Repayment is definite and being handled as agreed. Maintains a strong, liquid financial condition as evidenced by a current financial statement in the Bank.

•Grade 2 - Satisfactory Quality

Loans secured by properly margined collateral with a definite repayment agreement in effect. Unsecured loans with repayment agreements that are definite, realistic, and are being handled as agreed. Repayment source well defined by proven income, cash flow, trade asset turn, etc. Multiple repayment sources exist. Individual and businesses will typically have a sound financial condition.

•Grade 3 – Satisfactory - Merits Attention

Loans being repaid as agreed that require close following because of complexity, information or underwriting deficiencies, emerging signs of weakness or non-standard terms. Secured loans repaying as agreed where collateral value or marketability are questionable but do not materially affect risk. Repayment sources well defined by proven income, cash flow, trade asset turn, etc., but may be weaker than Grade 2. Loans to weak individuals or business borrowers with a strong endorser or

-21-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

guarantor. Fully collectible, unsecured loans or loans secured by other than approved collateral for which an acceptable repayment agreement has not been established.

•Grade 4 - Low Satisfactory

New Loans - Applicants with excessive minor exceptions as defined by the Risk Grade forms. Applicants with major credit history or beacon score issues as defined by the Risk Grade forms. Applicants with two or more major exceptions with mitigating factors identified on the Fair Lending form.

Existing Loans - Borrower’s ability to repay from primary (intended) repayment sources is not clearly sufficient to ensure performance as contracted; but the loan is performing as contracted, and secondary repayment sources are clearly sufficient to protect against the risk of principal or income loss; and it is reasonable to expect that the circumstances causing repayment capacity to be uncertain will be resolved within six months. Access to alternative financing sources exists but may be limited to institutions specializing in higher risk financing.

•Grade 5 - Special Mention

Special Mention is an additional risk grade not available on the Grading Form. Loans are not typically made if the grade is Special Mention at inception, without management's approval. These loans include the following characteristics: Loans currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the bank’s position at some future date. Loans are not typically made if graded special mention at inception, without management's approval. Potential weaknesses exist generally as a result of deviations from prudent lending practices, such as over advances on collateral or unproven primary repayment sources. Loans where adverse economic conditions develop subsequent to the loan origination, that do not jeopardize liquidation of the debt but do increase the level of risk, may also warrant this rating. Such trends may be in the borrower’s options, credit quality or financial strength. Also may include new loans with exceptions, where no mitigating factors are justified.


•	Grade 6 -8 - Substandard or Worse

Substandard, Doubtful, and Loss are additional risk grades not available on the Grading Form. Loans are not typically made if graded Substandard or worse at inception, without management's approval. A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as Substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loans classified as Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be affected in the future.

-22-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Credit Risk Profile by Creditworthiness Class and Credit Card Portfolio Exposure

The following tables are an analysis of the creditworthiness class by loan class and credit card portfolio exposure as of June 30, 2013 and December 31, 2012.



	June 30, 2013
			Real Estate
	Commercial and Industrial		Commercial Construction and Land Development		Commercial Real Estate		Residential Construction		Residential Mortgage		Consumer		Other		Totals
	(amounts in thousands)
1 - Lowest Risk	$	1,988	$	—	$	—	$	—	$	—	$	1,376	$	12	$	3,376
2 - Satisfactory Quality	726		421		3,058		—		9,644		282		—		14,131
3 - Satisfactory
- Merits Attention	10,116		19,958		63,681		2,147		54,964		4,182		644		155,692
4 - Low Satisfactory	12,103		32,206		99,892		20,156		70,551		1,102		118		236,128
5 - Special mention	394		7,274		7,562		779		8,777		66		133		24,985
6-8 - Substandard	1,238		19,503		12,131		1,181		17,870		60		—		51,983
	$	26,565	$	79,362	$	186,324	$	24,263	$	161,806	$	7,068	$	907	$	486,295



	June 30, 2013
	Consumer - Credit Card		Business- Credit Card
	(amounts in thousands)
Performing	$	2,112	$	1,136
Non Performing	27		—
Total	$	2,139	$	1,136

Total Loans			$	489,570



	December 31, 2012
			Real Estate
	Commercial and Industrial		Commercial Construction and Land Development		Commercial Real Estate		Residential Construction		Residential Mortgage		Consumer		Other		Totals
	(amounts in thousands)
1 - Lowest Risk	$	2,446	$	—	$	—	$	—	$	51	$	1,372	$	13	$	3,882
2 - Satisfactory Quality	441		595		2,429		109		10,595		288		—		14,457
3 - Satisfactory
- Merits Attention	10,222		22,278		51,384		1,337		58,140		4,526		1,091		148,978
4 - Low Satisfactory	13,558		35,502		104,652		17,008		68,148		1,019		125		240,012
5 - Special mention	323		9,064		6,228		356		9,720		91		49		25,831
6-8 - Substandard	1,387		23,460		16,501		1,635		18,355		103		—		61,441
	$	28,377	$	90,899	$	181,194	$	20,445	$	165,009	$	7,399	$	1,278	$	494,601

-23-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	December 31, 2012
	Consumer- Credit Card		Business- Credit Card
	(amounts in thousands)
Performing	$	2,233	$	1,186
Non Performing	32		—
Total	$	2,265	$	1,186

Total Loans			$	498,052

Age Analysis of Past Due Loans

The following tables are an age analysis of past due loans by loan class, as of June 30, 2013 and December 31, 2012.



	June 30, 2013
	30-89 Days Past Due		Nonaccrual and Greater than 90 Days Past Due			Total Past Due		Current		Total Loans		Recorded Investment > 90 Days and Accruing
	(amounts in thousands)
Commercial & industrial	$	7	$	898	—	$	905	$	25,660	$	26,565	$	—
Commercial construction and land Development	950		13,041			13,991		65,371		79,362		—
Commercial real estate	833		7,901			8,734		177,590		186,324		—
Residential construction	47		695			742		23,521		24,263		—
Residential mortgage	876		11,402			12,278		149,528		161,806		—
Consumer	115		22			137		6,931		7,068		—
Consumer credit cards	67		27			94		2,045		2,139		27
Business credit cards	9		—			9		1,127		1,136		—
Other loans	46		—			46		861		907		—
Total	$	2,950	$	33,986		$	36,936	$	452,634	$	489,570	$	27



	December 31, 2012
	30-89 Days Past Due		Nonaccrual and Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days and Accruing
	(amounts in thousands)
Commercial & industrial	$	119	$	664	$	783	$	27,594	$	28,377	$	—
Commercial construction and land Development	819		15,941		16,760		74,139		90,899		—
Commercial real estate	499		9,091		9,590		171,604		181,194		—
Residential construction	—		833		833		19,612		20,445		—
Residential mortgage	1,076		9,408		10,484		154,525		165,009		—
Consumer	34		33		67		7,332		7,399		—
Consumer credit cards	67		32		99		2,166		2,265		32
Business credit cards	12		—		12		1,174		1,186		—
Other loans	—		—		—		1,278		1,278		—
Total	$	2,626	$	36,002	$	38,628	$	459,424	$	498,052	$	32

-24-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Impaired Loan by Loan Class

When the Bank determines that a loan is impaired, an analysis is performed to determine the appropriate method in which to measure impairment. For those loans determined to be collateral dependent, an updated collateral value is obtained based on where the loan is in the collection process and the age of the existing appraisal. Each piece of collateral is analyzed to identify potential sales costs and additional discounts due to property type and/or quality of the approval resulting in the collateral's fair value. This amount is then compared to the legal balance of the loan to estimate potential loss which could result in a write down on the loan or a specific reserve. Appraised values on real estate collateral are subject to constant change and management makes certain assumptions about how the age of an appraisal impacts current value. The Company has $10.1 million in loans in the coastal North Carolina region which are collateralized by properties that have seen significant declines in value, $161,000 of which is currently impaired. Impairment is measured using a discounted value of expected future cash flows for a portion of loans determined not to be collateral dependent. Impaired loans are re-evaluated periodically to determine the adequacy of specific reserves and prior charge-offs. Impaired loans decreased by 17.7% to $48.5 million at June 30, 2013 from $58.9 million at December 31, 2012.

The reasons for the reduction in the recorded investment of impaired loans between December 31, 2102 and June 30, 2013 resulted from approximately $4.1 million in charge offs, principal reductions of $4.4 million and $3.7 million in impaired loans that were either upgraded or otherwise removed from impairment due to improvement in the repayment capacity of the borrowers or guarantors. Additionally, $1.2 million in balances were transferred to OREO and approximately $3.0 million of loans were newly classified as impaired during the reporting period.

-25-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The following table illustrates the impaired loans by loan class as of June 30, 2013 and December 31, 2012.



	June 30, 2013
							Quarter to Date				Year to Date
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(amounts in thousands)
With no related allowance recorded:
Commercial and industrial	$	454	$	377	$	—	$	391	$	4	$	401	$	9
Commercial construction and land development	13,580		20,065		—		14,577		2		15,195		9
Commercial real estate other	12,862		15,299		—		12,447		56		12,553		115
Residential construction	695		1,134		—		771		—		802		—
Residential mortgage	13,704		13,546		—		12,463		48		12,739		122
Consumer	22		14		—		5		—		8		—
Subtotal:	41,317		50,435		—		40,654		110		41,698		255

With an allowance recorded:
Commercial and industrial	$	792	$	792	$	338	$	804	$	—	$	819	$	4
Commercial construction and land development	2,528		2,665		348		2,528		1		2,537		4
Commercial real estate other	2,530		2,823		509		2,651		19		2,685		37
Residential construction	—		—		—		—		—		—		—
Residential mortgage	1,287		1,305		253		1,291		4		1,296		14
Consumer	—		—		—		—		—		—		—
Subtotal:	7,137		7,585		1,448		7,274		24		7,337		59

Totals:
Commercial	$	32,746	$	42,021	$	1,195	$	33,398	$	82	$	34,190	$	178
Consumer	22		14		—		5		—		8		—
Residential	15,686		15,985		253		14,525		52		14,837		136
Grand Total	$	48,454	$	58,020	$	1,448	$	47,928	$	134	$	49,035	$	314

-26-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	December 31, 2012
							Year to Date
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(amounts in thousands)
With no related allowance recorded:
Commercial and industrial	$	498	$	686	$	—	$	484	$	1
Commercial construction and land development	11,266		15,889		—		13,008		22
Commercial real estate other	12,865		14,263		—		12,328		64
Residential construction	340		340		—		162		—
Residential mortgage	10,106		11,542		—		9,937		132
Consumer	25		42		—		26		—
Other	—		—		—		—		—
Subtotal:	35,100		42,762		—		35,945		219

With an allowance recorded:
Commercial and industrial	$	939	$	956	$	636	$	528	$	11
Commercial construction and land development	9,619		13,033		1,693		10,003		36
Commercial real estate other	4,877		6,852		640		5,623		46
Residential construction	833		1,134		86		884		—
Residential mortgage	7,467		8,081		2,334		7,493		44
Consumer	25		34		—		25		—
Other	—		—		—		—		—
Subtotal:	23,760		30,090		5,389		24,556		137

Totals:
Commercial	40,064		51,679		2,969		41,974		180
Consumer	50		76		—		51		—
Residential	18,746		21,097		2,420		18,476		176
Grand Total	$	58,860	$	72,852	$	5,389	$	60,501	$	356

Loans on Nonaccrual Status

The following table illustrates nonaccrual loans by loan class as of June 30, 2013 and December 31, 2012.



	June 30, 2013		December 31, 2012
	(amounts in thousands)
Commercial & industrial	$	898	$	664
Commercial construction and land development	13,041		15,941
Commercial real estate	7,901		9,091
Residential construction	695		833
Residential mortgage	11,402		9,408
Consumer	22		33
Total	$	33,959	$	35,970

-27-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Troubled Debt Restructurings

For the three and six months ended months ended June 30, 2013

Loans are classified as a troubled debt restructuring (“TDR”) when, for economic or legal reasons related to the debtor's financial difficulties, the Bank grants a concession to the debtor that would not otherwise be considered. Generally, these loans are restructured due to a borrower's inability to repay or meet the contractual obligations under the loan, which predominantly occurs because of cash flow problems. The Bank only restructures loans for borrowers in financial difficulty that demonstrate the willingness and capacity to repay the loan under reasonable terms and where the Bank has sufficient protection provided by the cash flow potential of the underlying collateral or business. We may grant concessions by (1) forgiving principal or interest, (2) reducing the stated interest rate to a below market rate, (3) deferring principal payments, (4) changing repayment terms from amortizing to interest only, (5) extending the repayment period, or (6) accepting a change in terms based on a bankruptcy plan.

Loans being renewed or modified are reviewed by the Bank to determine if the risk grade assigned is accurate based on updated information. All loans graded a “5” or worse at or prior to renewal or modification are also reviewed to determine if the loan should be classified as a TDR. The Bank's knowledge of the borrower's situation and any updated financial information obtained is first used to determine whether the borrower is experiencing financial difficulty. The Bank then reviews the requested modification terms to determine if a concession has been made. If the Bank determines the answer to both of the above items is yes, the loan will be classified as a TDR. If the Bank determines the answer to either of these questions is no, the loan is not classified as a TDR. Documentation to support this review and determination of classification is maintained with the credit file.

The Bank's policy with respect to accrual of interest on loans restructured as part of a TDR follows relevant supervisory guidance. If a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If the borrower was materially delinquent on payments prior to the restructuring, but shows the capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual until such time as continued performance has been demonstrated, which is typically a period of at least six consecutive monthly payments. If the borrower does not perform under the restructured terms, the loan would remain on or be placed on nonaccrual status. We will continue to closely monitor these loans and will cease accruing interest on them if management believes that the borrowers may not continue performing based on the restructured terms. However, all TDRs are considered to be impaired and are evaluated as such in the quarterly allowance calculation.

The following table provides a summary of loans modified as TDRs at June 30, 2013 and December 31, 2012.



June 30, 2013:	Accrual		Nonaccrual		Total TDRs		Allowance for Loan Losses Allocated
Commercial & Industrial	$	348	$	36	$	384	$	25
Commercial Construction and Land Development	3,066		8,558		11,624		—
Commercial real estate	5,522		4,320		9,842		291
Residential mortgage	3,456		2,789		6,245		240
Consumer	—		4		4		—
Total modifications	$	12,392	$	15,707	$	28,099	$	556



December 31, 2012	Accrual		Nonaccrual		Total TDRs		Allowance for Loan Losses Allocated
Commercial & Industrial	$	349	$	88	$	437	$	45
Commercial Construction and Land Development	4,466		9,677		14,143		—
Commercial real estate	5,522		4,437		9,959		922
Residential mortgage	3,945		3,112		7,057		372
Total modifications	$	14,282	$	17,314	$	31,596	$	1,339

-28-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The following table presents a breakdown of new TDRs by loan class and the type of concession made to the borrower, for the three and six months ended June 30, 2013.



		Three Months Ended					Six Months Ended
		June 30, 2013					June 30, 2013
		Number of loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of loans	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
		(amounts in thousands, except number of loans)
Below market interest rate
	Commercial real estate	—	$	—	$	—	1	$	468	$	468
	Subtotal	—	—		—		1	468		468

Extended payment terms
	Commercial real estate	—	$	—	$	—	4	$	167	$	167
	Residential mortgage	—	—		—		3	203		203
	Subtotal	—	—		—		7	370		370
Other
	Commercial real estate	—	$	—	$	—	1	$	37	$	37

	Total	—	$	—	$	—	9	$	875	$	875

Current Bank policy considers a loan to be in payment default at the time that the loan is placed on nonaccrual. For the three and six months ended June 30, 2013, there were no payment defaults on fully charged off loans which were modified during the prior twelve months.

The table below details successes and failures of TDRs that we have entered into during the twelve months ended June 30, 2013. There have been nine TDRs executed during the previous 12 months, of which one resulted in default by the borrower, as $30,000 was accepted as settlement and the remainder of $.2 million was charged off. Notes totaling $191,000 are paying as agreed in the restructure, and notes totaling $684,000 were converted to non-accrual.



		For the 12 month period ended June 30, 2013
		Paid in full			Paying as restructured			Converted to non-accrual			Foreclosure/Default
		Number of loans	Recorded Investment		Number of loans	Recorded Investment		Number of loans	Recorded Investment		Number of loans	Recorded Investment
		(amounts in thousands, except number of loans)
Below market interest rate		—	$	—	—	$	—	1	$	468	—	$	—
Extended payment terms		—	—		2	191		4	179		1	—
Forgiveness of principal		—	—		—	—		—	—		—	—
Other		—	—		—	—		1	37		—	—
	Total	—	$	—	2	$	191	6	$	684	1	$	—

NOTE F – FAIR VALUE MEASUREMENT

The Company records securities available for sale at fair value on a recurring basis. Fair value is a market-based measurement and is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the assets or owes the liability. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the transaction and the asset or liability, the principal or most advantageous market for the asset or liability, and market participants with whom the entity would transact in the market.

-29-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures” (“ASC 820”) establishes a fair value hierarchy to prioritize the inputs of valuation techniques used to measure fair value. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of how market-observable the fair value measurement is and defines the level of disclosure. ASC 820 clarifies fair value in terms of the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability at the measurement date (an exit price). In order to determine the fair value or the exit price, entities must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the reporting entity to define the inputs for fair value and level of hierarchy.

Outlined below is the application of the fair value hierarchy established by ASC 820 to the Company’s financial assets that are carried at fair value.

Level 1 – Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. An active market for the asset or liability is a market in which the transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2 – Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 – Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Unobservable inputs are supported by little or no market activity or by the entity’s own assumptions.

Fair Value Measured on a Recurring Basis. The Company measures certain assets at fair value on a recurring basis, as described below.

Investment Securities Available for Sale

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by the Government National Mortgage Association (“GNMA”), the Federal National Mortgage Association ("FNMA"), municipal bonds and corporate debt securities.

Securities classified as Level 3 include trust preferred securities. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Management has continued to monitor the creditworthiness of the issuers of trust preferred securities during the second quarter of 2013 in considering similar key factors. As of the date of the most recently available financial information, the issuers' market value, credit rating, income, and capital ratios have all increased.

As of June 30, 2013, the fair value of the Company's investments in available-for-sale Level 3 trust preferred securities was $1.0 million. These securities consist of two single issuer trust preferred securities and are floating rate securities based off of three month LIBOR plus a spread of 5.0% and a weighted average maturity of 6 years. The issuers of these securities are community bank financial institutions operating primarily in North Carolina.

To estimate their fair value, the Company's third party investment pricing organization used a valuation model, which is based on a discounted cash flow approach. While both securities have call features associated with them, given the current economic and regulatory environment, it has been assumed that for valuation purposes, these securities will be outstanding until maturity. The most significant input for the valuation model is the discount rate used in the analysis. Both the actual floating rate and estimated market rate of the securities are swapped to a comparable fixed rate using the LIBOR swap curve as of the valuation date. In the current environment, a fixed rate of 9.0% was used given the presence of preferred shares issued to the US Treasury under the Capital Purchase Program. The present value of the difference between the two rates is taken to determine the market value of the security.

-30-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The following table presents information about assets measured at fair value on a recurring basis at June 30, 2013 and December 31, 2012.



					Fair Value Measurements at
					June 30, 2013, Using
	Total Carrying Amount in the Consolidated Balance Sheet		Assets Measured at Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	6/30/2013		6/30/2013		(Level 1)		(Level 2)		(Level 3)
	(amounts in thousands)
Taxable municipal securities	$	1,521	$	1,521	$	—	$	1,521	$	—
Mortgage-backed securities
GNMA	3,187		3,187		—		3,187		—
FNMA	—		—		—		—		—
Trust preferred securities	1,019		1,019		—		—		1,019
Equity securities	123		123		59		64		—
Total available for sale securities	$	5,850	$	5,850	$	59	$	4,772	$	1,019



					Fair Value Measurements at
					December 31, 2012, Using
	Total Carrying Amount in the Consolidated Balance Sheet		Assets Measured at Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	12/31/2012		12/31/2012		(Level 1)		(Level 2)		(Level 3)
	(amounts in thousands)
Taxable municipal securities	$	5,913	$	5,913	$	—	$	5,913	$	—
Mortgage-backed securities
GNMA	60,743		60,743		—		60,743		—
FNMA	5,880		5,880		—		5,880		—
Trust preferred securities	1,006		1,006		—		—		1,006
Equity securities	180		180		56		124		—
Total available for sale securities	$	73,722	$	73,722	$	56	$	72,660	$	1,006

-31-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The following table presents the reconciliation for the three and six months ended June 30, 2013 and 2012 for all Level 3 assets that are measured at fair value on a recurring basis.



	For the Three Months Ended					For the Six Months Ended
	June 30,					June 30,
	Securities available-for-sale					Securities available-for-sale
	2013		2012			2013		2012
	(amounts in thousands)
Beginning Balance	$	1,019	$	1,022		$	1,019	$	1,085
Total realized and unrealized gains or (losses):
Included in earnings	—		—			—		—
Included in other comprehensive income (loss)	—		(3		)	—		(66		)
Purchases, issuances and settlements	—		—			—		—
Transfers in (out) of Level 3	—		—			—		—
Ending Balance	$	1,019	$	1,019		$	1,019	$	1,019

Fair Value Measured on a Nonrecurring Basis. The Company measures certain assets at fair value on a nonrecurring basis, as described below.

Impaired Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC 310, “Receivables” and ASC 450, “Contingencies”. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At June 30, 2013, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with ASC 820, impaired loans with an allowance established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value that relies upon comparable values from identical sources, the Company records the impaired loan as nonrecurring Level 2. When a current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans totaled $48.5 million at June 30, 2013. Of such loans, $7.1 million had specific loss allowances aggregating $1.4 million at that date for a net fair value of $5.7 million. Of those specific allowances, all were determined using Level 3 inputs. For impaired loans with no specific allowance the Company has either determined that the fair value of the expected repayments or collateral exceeds the recorded investment in such loans or the loan has been partially charged-off to its fair value and as such a new cost basis has been established.

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a recurring and nonrecurring basis at June 30, 2013 (amounts in thousands, except percentages):



Total Carrying Amount
Nonrecurring measurements:
Impaired loans	$	5,689	Collateral discounts	15-70%
Foreclosed assets	$	11,776	Discounted appraisals	10-30%
Recurring measurements:
Trust preferred securities	$	1,019	Probability of default	10-20%
			Loss given default	100%

-32-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Foreclosed Assets

The carrying values of foreclosed assets are adjusted to not exceed the net realizable value upon transfer of the loans to foreclosed assets. Net realizable value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral adjusted for selling costs. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3. Through the six month period ended June 30, 2013, the Company recognized approximately $637,000 in valuation reductions on foreclosed assets and the carrying value of foreclosed assets was $11.8 million at June 30, 2013. As of and for the year ended December 31, 2012, there was $2.3 million recognized in valuation adjustments on foreclosed assets and the carrying value of foreclosed assets was $15.1 million at December 31, 2012.

The following table presents information about individually identified impaired loans and foreclosed assets measured at fair value at June 30, 2013 and December 31, 2012.



					Fair Value Measurements at
					June 30, 2013, Using
	Total Carrying Amount in the Consolidated Balance Sheet		Assets Measured at Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	6/30/2013		6/30/2013		(Level 1)		(Level 2)		(Level 3)
	(amounts in thousands)
Impaired loans	$	5,689	$	5,689	$	—	$	—	$	5,689
Foreclosed assets	$	11,776	$	11,776	$	—	$	—	$	11,776



					Fair Value Measurements at
					December 31, 2012, Using
	Total Carrying Amount in the Consolidated Balance Sheet		Assets Measured at Fair Value		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	12/31/2012		12/31/2012		(Level 1)		(Level 2)		(Level 3)
	(amounts in thousands)
Impaired loans	$	18,372	$	18,372	$	—	$	—	$	18,372
Foreclosed assets	$	15,136	$	15,136	$	—	$	—	$	15,136

NOTE G - FAIR VALUE OF FINANCIAL INSTRUMENTS

ASC 825, “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 due from banks, interest bearing due from banks, approximate to the fair values due to the liquid nature of the financial instruments and are classified as Level 1.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

CDs Held for Investment

The fair values are based on discounting expected cash flows at the interest rate for certificates of deposit with the same or similar remaining maturity.

Investment Securities

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. Fair value for investment securities held to maturity is determined using discounted cash flow analysis.

Loans

The Company does not record loans at fair value on a recurring basis. The fair value of loans has been estimated utilizing the net present value of future cash flows based upon contractual balances, prepayment assumptions, and applicable weighted average interest rates, adjusted for current liquidity and market discount assumption. 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. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Impaired loans are valued at the lower of cost or fair value. The methods utilized to estimate fair value of loans do not necessarily represent an exit price.

FHLB Stock

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

Deposits

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 2 classification. The carrying amount of certificates of deposit approximates their fair value at the reporting date. Fair value for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Subordinated Debentures, and Subordinated Notes

The fair value of subordinated debentures and subordinated promissory notes is based on discounting expected cash flows at the interest rate from debt with the same or similar remaining maturities and collection requirements, resulting in a Level 3 classification.

Borrowings

The fair value of borrowings as of June 30, 2013 is based on the monthly mark to market schedule published by the lender FHLB, which is indicative of current rates for similar borrowings of comparable remaining duration, resulting in a Level 2 classification.

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest approximate fair value.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The following table presents information for financial assets and liabilities as of June 30, 2013 and December 31, 2012.



	June 30, 2013
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:	(amounts in thousands)
Cash and cash equivalents	$	159,886	$	159,886	$	159,886	$	—	$	—
CDs held for investment	$	30,135	$	30,135	$	—	$	30,135	$	—
Securities available for sale	$	5,850	$	5,850	$	59	$	4,772	$	1,019
Securities held to maturity	$	105,319	$	104,341	$	—	$	104,341	$	—
Loans held for sale	$	1,016	$	1,016	$	—	$	—	$	1,016
Loans, net	$	475,200	$	451,803	$	—	$	—	$	451,803
FHLB stock	$	6,076	$	6,076	$	—	$	6,076	$	—
Accrued interest receivable	$	1,523	$	1,523	$	—	$	1,523	$	—

Financial liabilities:
Deposits	$	657,481	$	643,963	$	—	$	643,963	$	—
Subordinated debentures and promissory notes	$	24,372	$	15,598	$	—	$	—	$	15,598
Borrowings	$	112,000	$	122,165	$	—	$	122,165	$	—
Accrued interest payable	$	1,574	$	1,574	$	—	$	1,574	$	—



	December 31, 2012
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:	(amounts in thousands)
Cash and cash equivalents	$	183,150	$	183,150	$	183,150	$	—	$	—
CDs held for investment	$	26,460	$	26,460	$	—	$	26,460	$	—
Securities available for sale	$	73,722	$	73,722	$	56	$	72,660	$	1,006
Securities held to maturity	$	20,329	$	20,668	$	—	$	20,668	$	—
Loans held for sale	$	19,297	$	19,297	$	—	$	—	$	19,297
Loans, net	$	481,380	$	460,422	$	—	$	—	$	460,422
FHLB stock	$	6,415	$	6,415	$	—	$	6,415	$	—
Premises and equipment, held for sale	$	1,901	$	1,901	$	—	$	—	$	1,901
Accrued interest receivable	$	1,869	$	1,869	$	—	$	1,869	$	—

Financial liabilities:
Deposits	$	699,856	$	694,184	$	—	$	694,184	$	—
Subordinated debentures and promissory notes	$	24,372	$	15,598	$	—	$	—	$	15,598
Borrowings	$	112,000	$	126,738	$	—	$	126,738	$	—
Accrued interest payable	$	1,736	$	1,736	$	—	$	1,736	$	—

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

NOTE H – OTHER RECENT ACCOUNTING PRONOUNCEMENTS

New Accounting Standards

In December 2011, The Financial Accounting Standards Board ("FASB") issued (Accounting Standards Update) ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, amending ASC Topic 210 requiring an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The amendment is effective for annual and interim periods beginning on or after January 1, 2013. The adoption of this amendment did not have a material effect on the Company's consolidated financial statements.

In January 2013, the FASB issued ASU 2013-01, "Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities." The main objective of this Update is to address implementation issues about the scope of ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting and Liabilities. The guidance in this ASU is effective for the first interim or annual period beginning on or after January 1, 2013. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This update seeks to to improve the reporting of reclassifications out of accumulated other comprehensive income by requiring an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income, if the amount being reclassified is required under U.S. GAAP to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account (for example, inventory) instead of directly to income or expense in the same reporting period. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012. The adoption of this amendment did not have a material effect on the Company's consolidated financial statements.

Other accounting standards that have been issued 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.

NOTE I – SUBORDINATED NOTES

The Company is currently prohibited by the Written Agreement, described in Note J of these Notes to Consolidated Financial Statements, from paying interest on its subordinated promissory notes and on its subordinated debentures in connection with its trust preferred securities (TPS) without prior approval of the supervisory authorities. The Company and the Bank are prohibited from declaring or paying dividends without prior approval of the supervisory authorities. The Company obtained approval to pay the interest on its subordinated promissory notes for the second quarter of 2013. The Company exercised its right to defer regularly scheduled interest payments on its outstanding TPS and as of June 30, 2013, $598,000 of interest payments have been accrued for and deferred pursuant to the terms of the indenture governing the TPS. The Company may not pay any cash dividends on its Common Stock until it is current on interest payments on such TPS. The Company has not paid any cash dividends on its Common Stock since it suspended dividends in the fourth quarter of 2010. As a bank holding company, the Company’s ability to declare and pay dividends also depends on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

NOTE J - 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. No dividends were paid to the Company by the Bank during the six months ended June 30, 2013 or the years 2012 and 2011.

To be considered adequately capitalized, 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, Tier 1 capital to average assets of 4%. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios as set forth in the table below. The Bank’s actual capital amounts and ratios are also presented in the table below.



	Actual				Minimum For Capital Adequacy Purposes				Minimum To be Well Capitalized under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of June 30, 2013:	(amounts in thousands, except ratios)
Total Capital (to Risk Weighted Assets)	$	50,644	10.95	%	$	36,986	8.0	%	$	46,232	10.0	%
Tier I Capital (to Risk Weighted Assets)	44,763		9.68	%	18,493		4.0	%	27,739		6.0	%
Tier I Capital (to Average Assets)	44,763		5.58	%	32,101		4.0	%	40,126		5.0	%

As of December 31, 2012:
Total Capital (to Risk Weighted Assets)	$	50,044	10.20	%	$	39,246	8.0	%	$	49,057	10.0	%
Tier I Capital (to Risk Weighted Assets)	43,797		8.93	%	19,623		4.0	%	29,434		6.0	%
Tier I Capital (to Average Assets)	43,797		5.01	%	34,949		4.0	%	43,687		5.0	%

The Company is also subject to capital requirements. At June 30, 2013 and December 31, 2012, the Company’s total capital to risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to average assets were 10.82%, 6.38%, and 3.68%, and 10.17%, 5.93%, and 3.33%, respectively.

In late May 2011, the Company and the Bank entered into the Written Agreement with the FRB and the NCCOB. Under the terms of the Written Agreement, the Bank developed and submitted for approval, within the time periods specified, plans to:


•	revise lending and credit administration policies and procedures at the Bank and provide relevant training;


•	enhance the Bank's real estate appraisal policies and procedures;


•	enhance the Bank's loan grading and independent loan review programs;


•	improve the Bank's position with respect to loans, relationships, or other assets in excess of $750,000, which are now or in the future become past due more than 90 days, are on the Bank's problem loan list, or adversely classified in any report of examination of the Bank; and


•	review and revise the Bank's policy regarding the Bank's allowance for loan and lease losses and maintain a program for the maintenance of an adequate allowance.

In addition, the Bank has agreed that it will:


•	refrain from extending, renewing, or restructuring any credit to or for the benefit of any borrower, or related interest, whose loans or other extensions of credit have been criticized in any report of examination of the Bank absent prior approval by the Bank's board of directors or a designated committee of the board in accordance with the restrictions in the Written Agreement;


•	eliminate from its books, by charge-off or collection, all assets or portions of assets classified as “loss” in any report of examination of the Bank, unless otherwise approved by the FRB and the NCCOB; and


•	take all necessary steps to correct all violations of law or regulation cited by the FRB and the NCCOB.

In addition, the Company has agreed that it will:

-37-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)


•	refrain from taking any form of payment representing a reduction in capital from the Bank or make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities absent prior regulatory approval;


•	refrain from incurring, increasing, or guaranteeing any debt without the prior written approval of the FRB; and


•	refrain from purchasing or redeeming any shares of its stock without the prior written consent of the FRB.

Under the terms of the Written Agreement, both the Company and the Bank have agreed to:


•	submit for approval a joint plan to maintain sufficient capital at the Company on a consolidated basis and at the Bank on a stand-alone basis;


•	notify the FRB and the NCCOB if the Company's or the Bank's capital ratios fall below the approved capital plan's minimum ratios;


•	refrain from declaring or paying any dividends absent prior regulatory approval;


•	comply with applicable notice provisions with respect to the appointment of new directors and senior executive officers of the Company and the Bank and legal and regulatory limitations on indemnification and severance payments; and


•	submit annual business plans and budgets and quarterly joint written progress reports regarding compliance with the Written Agreement.

The Company is committed to expeditiously addressing and resolving the issues raised in the Written Agreement. As such, the Board of Directors has established an Enforcement Action Committee that meets regularly to monitor the Bank's progress on compliance with the Written Agreement. The Bank has made progress on multiple provisions included in the Written Agreement and continues to aggressively work to implement any necessary changes to policies and procedures. Several control changes have been implemented to address the identification and valuation of impaired loans, the support and validation of the allowance for loan losses, and the valuation of foreclosed assets. Additionally, the Bank has implemented additional controls around obtaining updated collateral valuations as required by regulation and has established new policies to further reduce commercial real estate concentrations, ensure current financial information is evaluated, and control interest only loans. The Bank also created a separate Special Assets department and added additional resources to provide adequate attention and expertise to problem loan management. Other areas also being addressed are the adequacy of credit resources, portfolio risk management and reporting,and consistency and compliance when dealing with loan workouts. A material failure to comply with the terms of the Written Agreement could subject the Company to additional regulatory actions and further restrictions on its business. These regulatory actions and resulting restrictions on the Company's business may have a material adverse effect on its future results of operations and financial condition.

Since the Company and the Bank entered the Written Agreement, management has had frequent and regular communication with the FRB and NCCOB. This communication has involved:


•	updates on the progress involving each of the actions outlined in the Written Agreement;


•	specific steps taken by the Company to remain in compliance with the Written Agreement; and


•	communications, verbally and via interim internal reports, regarding the financial status of the Company including, but not limited to, the Company's key capital ratios.

To date, the Company has not received any disagreement from the regulatory authorities regarding actions taken or contemplated. At this time, the Company is in partial compliance with the provisions of the Written Agreement.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

NOTE K - BRANCH SALE

On March 22, 2013, the Bank sold selected deposits and assets associated with two branches located in Rockingham and Southern Pines, North Carolina. The transaction was consummated pursuant to a definitive purchase and assumption agreement with First Bank of Troy, North Carolina, which was entered into on September 26, 2012. Under the terms of the purchase and assumption agreement First Bank assumed the selected customer deposits of both branches offset by the purchase of (i) the aggregate net book value of the real property and related tangible personal property of the Rockingham, North Carolina branch as well as the value of cash on hand at the Rockingham, North Carolina branch, (ii) the aggregate of certain loans for both branches and (iii) a 1% premium of the deposits assumed.

Subject to a one-hundred day settlement period, the final cash settlement of $39.6 million to First Bank resulted from the assumption of customer deposits of $57.4 million less a 1% premium of the deposits balance of $0.6 million, and the sale of $17.2 million of related assets comprised of $0.2 million in cash on hand, $1.9 million of real property and equipment and $15.1 million of loans valued at March 19, 2013.

-39-

ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information about the major components of the financial condition and results of operations of Four Oaks Fincorp, Inc. (the “Company”) and its subsidiaries and should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto in Part I, Item 1 of this Quarterly Report.

Regulatory Update

In late May 2011, the Company and Four Oaks Bank and Trust Company, the Company's wholly-owned subsidiary(the "Bank") entered into a formal written agreement (the “Written Agreement”) with the Federal Reserve Bank of Richmond ( “FRB”) and the North Carolina Office of the Commissioner of Banks (“NCCOB”). Under the terms of the Written Agreement, the Bank developed and submitted for approval, within the time periods specified, plans to:


•	revise lending and credit administration policies and procedures at the Bank and provide relevant training;


•	enhance the Bank's real estate appraisal policies and procedures;


•	enhance the Bank's loan grading and independent loan review programs;


•	improve the Bank's position with respect to loans, relationships, or other assets in excess of $750,000, which are now or in the future become past due more than 90 days, are on the Bank's problem loan list, or adversely classified in any report of examination of the Bank; and


•	review and revise the Bank's policy regarding the Bank's allowance for loan and lease losses and maintain a program for the maintenance of an adequate allowance.

In addition, the Bank has agreed that it will:


•	refrain from extending, renewing, or restructuring any credit to or for the benefit of any borrower, or related interest, whose loans or other extensions of credit have been criticized in any report of examination of the Bank absent prior approval by the Bank's board of directors or a designated committee of the board in accordance with the restrictions in the Written Agreement;


•	eliminate from its books, by charge-off or collection, all assets or portions of assets classified as “loss” in any report of examination of the Bank, unless otherwise approved by the FRB and the NCCOB; and


•	take all necessary steps to correct all violations of law or regulation cited by the FRB and the NCCOB.

In addition, the Company has agreed that it will:


•	refrain from taking any form of payment representing a reduction in capital from the Bank or make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities absent prior regulatory approval;


•	refrain from incurring, increasing, or guaranteeing any debt without the prior written approval of the FRB; and


•	refrain from purchasing or redeeming any shares of its stock without the prior written consent of the FRB.

Under the terms of the Written Agreement, both the Company and the Bank have agreed to:


•	submit for approval a joint plan to maintain sufficient capital at the Company on a consolidated basis and at the Bank on a stand-alone basis;


•	notify the FRB and the NCCOB if the Company's or the Bank's capital ratios fall below the approved capital plan's minimum ratios;


•	refrain from declaring or paying any dividends absent prior regulatory approval;


•	comply with applicable notice provisions with respect to the appointment of new directors and senior executive officers of the Company and the Bank and legal and regulatory limitations on indemnification and severance payments; and


•	submit annual business plans and budgets and quarterly joint written progress reports regarding compliance with the Written Agreement.

-40-

loan losses, and the valuation of foreclosed assets. Additionally, the Bank has implemented additional controls around obtaining updated collateral valuations as required by regulation and has established new policies to further reduce commercial real estate concentrations, ensure current financial information is evaluated, and control interest only loans. The Bank also created a separate Special Assets department and added additional resources to provide adequate attention and expertise to problem loan management. Other areas also being addressed are the adequacy of credit resources, portfolio risk management and reporting, and consistency and compliance when dealing with loan workouts. A material failure to comply with the terms of the Written Agreement could subject the Company to additional regulatory actions and further restrictions on its business. These regulatory actions and resulting restrictions on the Company's business may have a material adverse effect on its future results of operations and financial condition.

Since the Company and the Bank entered the Written Agreement, management has had frequent and regular communication with the FRB and NCCOB. This communication has involved:


•	updates on the progress involving each of the actions outlined in the Written Agreement;


•	specific steps taken by the Company to remain in compliance with the Written Agreement; and


•	communications, verbally and via interim internal reports, regarding the financial status of the Company including, but not limited to, the Company's key capital ratios.

Comparison of Financial Condition at

June 30, 2013 and December 31, 2012

The Company’s total assets declined $36.6 million during the period ending June 30, 2013 or 4.23% from a balance at December 31, 2012 of $865.5 million to $828.9 million at June 30, 2013. Cash and cash equivalents decreased approximately $23.3 million primarily due to the net payment of $39.6 million made to First Bank in connection with the branch sale representing the net sale of the customer deposits, cash, fixed assets and loans. Net loans declined $6.2 million due to payoffs, paydowns, and charge offs. Loans held for sale declined $18.3 million due to the closing of the First Bank sale on March 22, 2013. CDs held for investment increased $3.7 million and investment securities increased $17.1 million as cash was invested in higher yielding assets. The remaining changes in total assets were decreases in foreclosed assets of $3.4 million as sales outpaced additions, and a decline of $3.5 million in other assets due to a decrease in receivables for investment sales recorded in December 2012 that settled after year end.

Total deposits decreased $42.4 million or 6.05% for the period ended June 30, 2013 as compared to December 31, 2012. The decline was primarily due to the sale of $58.0 million of deposits to First Bank, which was offset by growth in deposits at the remaining branches. The increase in other liabilities of $6.4 million is due to investment purchases of $4.7 million that settled after June 30, 2013, the residual $1.5 million post closing settlement related to the branch sale, and $0.2 million of timing differences related to miscellaneous other liabilities.

Total shareholders’ equity declined from $22.7 million at December 31, 2012 to $22.3 million at June 30, 2013, primarily due to a net loss of $27,000 and other comprehensive loss of $0.6 million for the six months ended June 30, 2013.

Results of Operations for the Three Months Ended

June 30, 2013 and 2012

Net Income (loss). Net loss for the three months ended June 30, 2013 was $104,000, or $0.01 per basic and diluted share, as compared to net income of $29,000, or $0.00 per basic and diluted share, for the three months ended June 30, 2012, a slight decrease of $133,000 or $0.01 per basic and diluted share. The primary reason for the net loss in the second quarter of 2013 is a reduction in interest income from loans of $1.1 million which is a result of the decrease in average loans of $84.1 million from the same period in 2012.

Net Interest Income. 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.

-41-

Net interest income for the three months ended June 30, 2013 was $5.0 million, as compared to $5.4 million for the quarter ended June 30, 2012, a decrease of $0.4 million. The reduction in net interest income is primarily due to reductions in the loan portfolio and lower yields on investments, offset by lower interest expense on deposits. Additionally, the early calls of brokered deposits required recognition of the remaining unamortized premium which contributed to reductions in net interest income. Net interest margins increased 18 basis points from 2.47% to 2.65% for the quarter ended June 30, 2013 as compared to the quarter ended June 30, 2012. Average interest-earning assets decreased $113.5 million primarily due to decreases in the average loan portfolio of $84.1 million, and declines in average investment securities of $27.4 million.

Provision for Loan Losses. 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.

Our non-performing assets, which consist of loans past due 90 days or more, foreclosed assets, and loans in nonaccrual status, decreased to $45.8 million at June 30, 2013 from $51.2 million at December 31, 2012. This decrease was primarily due to the improvements in the housing market and real estate construction, and our improved processes for addressing these assets. During the three months ended June 30, 2013, no provision for the allowance for loan losses was recognized in earnings compared to a small release of the provision of $39,000 for the three months ended June 30, 2012. The release of a portion of the allowance for loan losses previously provided for is a result of improved credit quality as outlined in the subsequent Asset Quality section. Net charge-offs as a percentage of average loans increased 9 basis points, from 0.16% for the three month period ended June 30, 2012 to 0.25% for the three month period ended June 30, 2013. Non-accrual loans at June 30, 2013 were $34.0 million representing a decrease from $52.1 million at June 30, 2012, and from $36.0 million at December 31, 2012. In addition, the Company has $10.1 million in loans in the coastal North Carolina region which are collateralized by properties that have seen significant declines in value. The Company has evaluated these loans in determining its allowance for loan losses as of June 30, 2013, and has determined that its exposure to loss on these loans is either mitigated by the values of the underlying collateral or addressed by our current allowance for loan losses. At June 30, 2013, impaired loans, which include non-accrual loans, troubled debt restructuring and other impaired notes, were $48.5 million. Of these loans, $7.1 million have specific loss allowances that aggregate $1.4 million. Impaired loan charge-offs, upgrades, and principal reductions have reduced the impaired loan population from $58.9 million at December 31, 2012 to $48.5 million at June 30, 2013 resulting in the reduction of reserves allocated to impaired loans during the period of $3.9 million. The reduction in impaired loan reserves was the primary driver for the decrease in our allowance for loan losses to 2.87% of gross loans at June 30, 2013 as compared to 3.32% as of December 31, 2012. Management believes that the allowance is adequate to absorb probable losses inherent in the loan portfolio.

Non-Interest Income. Non-interest income for the quarter ended June 30, 2013 decreased $0.3 million to $1.7 million from $2.0 million for the same period ended June 30, 2012, primarily due to a decrease of $0.3 million in gains on sales of investment securities available for sale, and a decrease of $0.1 million in other non-interest income, representing the premiums on sale of the guaranteed portion of SBA loans, partially offset by an increase of $0.2 million in revenue from the mortgage origination division.

Non-Interest Expenses. Non-interest expense decreased $0.8 million to $6.8 million for the quarter ended June 30, 2013 as compared to a total of $7.6 million for the quarter ended June 30, 2012. The decrease is primarily related to a decrease in collections expenses of $0.2 million and expenses related to the holding of foreclosed property of $0.4 million.

Income Taxes. We regularly assess available positive and negative evidence to determine whether it is more likely than not that our deferred tax asset balances will be recovered. A valuation allowance is established when it is more likely than not that all or some portion of the deferred tax asset will not be realized. In order to determine if the deferred tax asset is realizable, we performed an analysis that evaluates historical pre-tax earnings, projected future earnings, credit quality trends, taxable temporary differences and the cause and probability of recurrence of those circumstances leading to current taxable losses. Based on historical negative credit quality trends and cumulative losses in 2010, 2011 and 2012, we did not consider any current or future taxable earnings in determining the recoverability of the deferred tax assets, and have therefore maintained a full valuation allowance against the net deferred tax asset. The Company will not record tax expense or tax benefit until positive operating earnings utilizing existing tax loss carry forwards result in exhibited performance, which would support the reinstatement of deferred tax assets.

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Results of Operations for the Six Months Ended

June 30, 2013 and 2012

Net Income (loss). Net loss for the six months ended June 30, 2013 was $27,000, or $0.00 per basic and diluted share, as compared to net income of $581,000, or $0.08 per basic and diluted share for the six months ended June 30, 2012. The decline of $608,000 or $0.08 per basic and diluted share results primarily from increases in loan loss provisions of $321,000, a decrease in non-interest expenses of $324,000, and a decrease in net interest income of $1.0 million which is offset by a $612,000 increase in non-interest income that resulted from a premium of $586,000 received from the sale of deposits to First Bank.

Net Interest Income. The primary component of earnings for the Bank is net interest income, which is the difference between interest income from loans and investment securities, and interest expense on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread, and margin. 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.

Net interest income for the six months ended June 30, 2013 was $10.3 million, a decrease of $1.0 million compared to the six months ended June 30, 2012. The decrease was primarily a result of the decrease in the loan portfolio, of which $19.3 million was classified as held for sale at the end of 2012. The average balance of total loans decreased from $581.9 million for the six months ended June 30, 2012, compared to $496.2 million for the same period ended June 30, 2013. The average interest rate for investment securities declined 102 basis points from 3.62% for the six months ending June 30, 2012, to 2.60%, for the same period ended June 30, 2013. Also time deposits decreased an average of $133.8 million, from an average of $446.3 million for the six months ended June 30, 2012 to an average of $312.5 million for the same period in 2013. Additionally, the average rates for time deposits decreased 51 basis points, from 1.58% for the six months ended June 30, 2012, to 1.07% for the same period in 2013. Net interest margin increased 16 basis points from 2.59% to 2.75% for the six month period ended June 30, 2013 as compared to the same period ended June 30, 2012.

Provision for Loan Losses and Summary of Loan Loss Experience

The allowance for loan losses represents management’s estimate of an appropriate amount to provide for known and inherent losses in the loan portfolio in the normal course of business. While management believes the methodology used to establish the allowance for loan losses incorporates the best information available at the time, future adjustments to the level of the allowance may be necessary and the results of operations could be adversely affected should circumstances differ substantially from the assumptions initially used. We believe that the allowance for loan losses was established in conformity with generally accepted accounting principles; however, there can be no assurances that the regulatory agencies, after reviewing the loan portfolio, will not require management to increase the level of the allowance. Likewise, there can be no assurance that the existing allowance for loan losses is adequate should there be deterioration in the quality of any loans or changes in any of the factors discussed above. Any increases in the provision for loan losses resulting from such deterioration or change in condition could adversely affect our financial condition and results of operations.

The allowance for loan losses at June 30, 2013 was $14.0 million, which represents 2.87% of total loans outstanding compared to $16.5 million or 3.32% as of December 31, 2012. For the six months ended June 30, 2013, net loan charge-offs were $2.5 million compared with $2.4 million for the six months ended June 30, 2012, and non-accrual loans were $34.0 million and $36.0 million at June 30, 2013 and December 31, 2012, respectively.

Our non-performing assets, which consist of loans past due 90 days or more, foreclosed assets, and loans in nonaccrual status, decreased to $45.8 million at June 30, 2013 from $51.1 million at December 31, 2012. This decrease was primarily due to a decrease in nonaccrual loans of $2.0 million, and a decrease in foreclosed assets of $3.4 million. During the six months ended June 30, 2013, a $35,000 provision was made for the allowance for loan losses compared to a $286,000 reduction in the provision for the six months ended June 30, 2012. At June 30, 2013, impaired loans, which include non-accrual loans, troubled debt restructurings, and other impaired loans, totaled $48.5 million compared to $58.9 million at December 31, 2012. Of these loans, $7.1 million have specific reserves that aggregate to $1.4 million compared to $23.8 million with $5.4 million in specific reserves as of December 31, 2012, decreases of $16.6 million and $3.9 million, respectively. Our allowance for loan losses decreased to 2.87% of gross loans at June 30, 2013 from 3.32% at December 31, 2012. Management believes that the allowance is adequate to absorb possible losses inherent in the loan portfolio.

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Non-Interest Income. Non-interest income increased $0.6 million for the six months ended June 30, 2013 to $1.7 million as compared to $2.0 million for the same period in 2012. This increase was the result of the gain from the sale of two branches to First Bank in the amount of $0.6 million, and non-interest income generated by the mortgage services division of $0.3 million, offset by a decrease in the gain on available for sale securities of $0.3 million.

Non-Interest Expenses. Non-interest expenses decreased $324,000 to $14.1 million for the six months ended June 30, 2013 compared to $14.4 million for the six months ended June 30, 2012. The primary decreases in non-interest expenses were due to decreases in the losses on the sale and writedowns of foreclosed assets of $153,000, a decrease in FDIC assessment premiums of $199,000, and a reduction in collection expenses of $307,000, offset by increases in professional and consulting fees of $113,000, salaries and benefits of $234,000, and other operating expenses of $58,000.

Income Taxes. We regularly assess available positive and negative evidence to determine whether it is more likely than not that our deferred tax asset balances will be recovered. A valuation allowance is established when it is more likely than not that all or some portion of the deferred tax asset will not be realized. In order to determine if the deferred tax asset is realizable, we performed an analysis that evaluates historical pre-tax earnings, projected future earnings, credit quality trends, taxable temporary differences and the cause and probability of recurrence of those circumstances leading to current taxable losses. Based on historical negative credit quality trends and cumulative losses, we did not consider any current or future taxable earnings in determining the recoverability of the deferred tax assets, and have therefore maintained a full valuation allowance against the net deferred tax asset. The Company will not record tax expense or tax benefit until positive operating earnings utilizing existing tax loss carry forwards result in exhibited performance, which would support the reinstatement of deferred tax assets.

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Asset Quality

The following table presents past due and nonaccrual loans as of June 30, 2013 and December 31, 2012.



	June 30, 2013			December 31, 2012
Nonaccrual loans:	(amounts in thousands, except ratios)
Commercial and industrial	$	898		$	664
Commercial construction and land development	13,041			15,941
Commercial real estate	7,901			9,091
Residential construction	695			833
Residential mortgage	11,402			9,408
Consumer	22			33
Total nonaccrual loans	$	33,959		$	35,970

Foreclosed assets:
Commercial and industrial	$	50		$	71
Commercial construction and land development	6,922			8,363
Commercial real estate	3,382			2,420
Residential construction	107			602
Residential mortgage	1,315			3,680
Total foreclosed assets	$	11,776		$	15,136

Past due 90 days or more and still accruing:
Business credit cards	$	—		$	—
Consumer credit cards	27			32
Total past due 90 days and still accruing	$	27		$	32

Total nonperforming assets	$	45,762		$	51,138

Nonaccrual loans to gross loans	6.94		%	7.23		%
Nonperforming assets to total assets	5.52		%	5.91		%
Allowance coverage of nonperforming loans	41.31		%	45.97		%

Non-accrual loans as a percentage of gross loans has decreased to 6.94% as of June 30, 2013 compared to 7.23% as of December 31, 2012. The allowance for loan losses as a percentage of non-accrual loans has decreased to 41.31% as of June 30, 2013 compared to 45.97% as of December 31, 2012. The decrease in the allowance for loan losses primarily resulted from decreases in the specific reserves on impaired loans. The allowance for loan losses on impaired loans totaled $1.4 million as of June 30, 2013, compared to $5.389 million as of December 31, 2012, a 73% decrease. The allowance for loan losses on the loans reviewed collectively as part of the Bank's ASC 450 analysis has increased from $11.2 million as of December 31, 2012 to $12.3 million as of June 30, 2013. The allowance for loan losses as a percentage of loans reviewed collectively has increased from 2.54% at December 31, 2012 to 2.77% at June 30, 2013 due to the impact of charge-offs on the loss history and a reduction in total loans.

During the third quarter of 2012 the Bank formalized a review of performing non-accrual loans to determine if any could be returned to accrual status. The loans were reviewed to determine if the bank expected full repayment of amounts owed over a reasonable time frame. Among other things, the review included:


•	a review of the reason the loan was placed on non-accrual,


•	a review of the loan status to determine if it was current,


•	a review of the payment history to determine if consistent payments have been made for a sustained period of time,


•	a review of current payment terms to determine if repayment can be expected over a reasonable period of time


•	a review of updated financial information, and


•	performance of an updated cash flow analysis

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Loans are classified as troubled debt restructuring ("TDR") when, for economic or legal reasons related to the debtor’s financial difficulties, the Bank grants a concession to the debtor that would not otherwise be considered. Generally, these loans are restructured due to a borrower’s inability to repay or meet the contractual obligations under the loan, which predominantly occurs because of cash flow problems. We only restructure loans for borrowers in financial difficulty that demonstrate the willingness and capacity to repay the loan under reasonable terms and where the Bank has sufficient protection provided by the cash flow potential of the underlying collateral or business. We may grant concessions by (1) forgiving principal or interest, (2) reducing the stated interest rate to a below market rate, (3) deferring principal payments, (4) changing repayment terms from amortizing to interest only, (5) extending the repayment period, or (6) accepting a change in terms based on a bankruptcy plan.

The Bank's policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. If a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If the borrower was materially delinquent on payments prior to the restructuring but shows the capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual until such time as continued performance has been demonstrated, which is typically a period of at least six consecutive payments. If the borrower does not perform under the restructured terms, the loan is placed on nonaccrual status. We will continue to closely monitor these loans and will cease accruing interest on them if management believes that the borrowers may not continue performing based on the restructured terms.

All TDRs are considered to be impaired and are evaluated as such in the allowance calculation. The allowance for loan losses allocated to performing TDRs totaled $0.2 million and $1.0 million at June 30, 2013 and December 31, 2012, respectively. The allowance for loan losses allocated to nonperforming TDRs totaled $0.3 million and $0.6 million at June 30, 2013 and December 31, 2012, respectively.

The following table presents performing and nonperforming TDRs at June 30, 2013 and December 31, 2012.



	June 30, 2013		December 31, 2012
Performing TDRs:	(amounts in thousands)
Commercial industrial	$	348	$	349
Commercial construction and land development	3,066		3,484
Commercial real estate	5,522		5,522
Residential mortgage	3,456		3,945
Total performing TDRs	$	12,392	$	13,300



	June 30, 2013		December 31, 2012
Nonperforming TDRs:	(amounts in thousands)
Commercial industrial	$	36	$	87
Commercial construction and land development	8,558		10,659
Commercial real estate	4,320		4,437
Residential mortgage	2,789		3,113
Consumer	4		—
Total nonperforming TDRs	$	15,707	$	18,296

Other impaired loans are loans which are currently performing and are not included as nonaccrual or restructured loans above, but about which we have serious doubts as to the borrower’s ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or restructured loans, so they are evaluated individually by management in assessing the adequacy of our allowance for loan losses.

At June 30, 2013 there were 180 foreclosed properties valued at a total of $11.8 million and 215 nonaccrual loans totaling $34.0 million. At December 31, 2012, there were 148 foreclosed properties valued at a total of $15.1 million and 208 nonaccrual loans totaling $36.0 million.

The gross interest income that would have been recorded for non-performing loans for the six months ended June 30, 2013 and June 30, 2012, was approximately $2.3 million and $3.3 million, respectively. The amount of interest recognized for performing TDRs during the first six months of 2013 was approximately $209,089.

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The following table summarizes the Bank’s allocation of allowance for loan losses by loan category at June 30, 2013, and December 31, 2012.



	June 30, 2013				December 31, 2012
	Amount		% of Loans in each category		Amount		% of Loans in each category
	(amounts in thousands, except ratios)
Commercial and industrial	$	969	7	%	$	1,185	13	%
Commercial construction and land development	6,574		47	%	7,251		41	%
Commercial real estate	2,763		20	%	2,961		18	%
Residential construction	449		3	%	423		4	%
Residential mortgage	3,013		21	%	4,471		22	%
Consumer	178		1	%	188		2	%
Other	92		1	%	70		—	%
Total	$	14,038	100	%	$	16,549	100	%

A summary of the allowance for the three and six months ended June 30, 2013 and 2012 is as follows:



	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
	(amounts in thousands)
Balance, beginning of period	$	15,247		$	19,383		$	16,549		$	21,141
Provision for loan losses	—			(39		)	35			(286		)
Allowance before net (charge-offs) recoveries	15,247			19,344			16,584			20,855

Loans charged-off	(2,732		)	(1,691		)	(4,349		)	(3,724		)
Recoveries	1,523			765			1,803			1,287
Net (charge-offs) recoveries	(1,209		)	(926		)	(2,546		)	(2,437		)

Balance, end of period	$	14,038		$	18,418		$	14,038		$	18,418

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The following table summarizes the Bank's loan loss experience for the three and six months ended June 30, 2013 and 2012.



	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
	(amounts in thousands, except ratios)
Balance at beginning of period	$	15,247		$	19,383		$	16,549		$	21,141

Charge-offs:
Commercial and industrial	25			180			43			407
Business credit cards	17			11			17			33
Commercial construction and land development	1,198			982			1,858			2,155
Commercial real estate	987			146			1,225			486
Residential construction	138			35			138			35
Residential mortgage	294			127			904			278
Consumer	38			201			105			314
Consumer credit card	35			9			59			16
Total charge-offs	2,732			1,691			4,349			3,724
Recoveries:
Commercial and industrial	224			86			242			112
Business credit cards	4			—			9			—
Commercial construction and land development	91			480			178			800
Commercial real estate	1,007			118			1,008			178
Residential construction	—			—			—			—
Residential mortgage	158			21			281			106
Consumer	38			58			81			86
Consumer credit card	1			2			4			5
Total recoveries	1,523			765			1,803			1,287

Net (charge-offs)	(1,209		)	(926		)	(2,546		)	(2,437		)

Provision for loan losses - increase	—			(39		)	35			(286		)

Balance at end of period	$	14,038		$	18,418		$	14,038		$	18,418

Ratio of net charge-offs during the period to average gross loans outstanding during the period	0.25		%	0.16		%	0.51		%	0.42		%

Net charge-offs remained relatively close to 2012 levels, as the Bank continues to work through problem loans. The Bank added additional dedicated resources in 2012 to focus on the resolution of nonperforming assets.

Because of the nature of the Company’s primary markets and business, a significant portion of the loan portfolio is secured by commercial real estate, including residential and commercial acquisition, development, and construction properties. As of June 30, 2013 approximately 92.3% of the loan portfolio had real estate as a primary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower. Real estate values in many markets have declined over the past year, which may continue to negatively impact the ability of certain borrowers to repay their loans, while other markets are recovering their values. The Company continues to thoroughly review and monitor its commercial real estate concentration and sets limits by sector and region based on this internal review.

The Company utilizes interest reserves on certain commercial real estate loans to fund the interest payments which are funded from loan proceeds. The decision to establish a loan-funded interest reserve upon origination of a loan is based on the feasibility of the project, the creditworthiness of the borrower and guarantors and the protection provided by the real estate and other collateral. For the lender, an interest reserve may provide an effective means for addressing the cash flow characteristics of a properly

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underwritten acquisition, development and construction loan. Similarly, for the borrower, interest reserves may provide the funds to service the debt until the property is developed, and cash flow is generated from the sale or lease of the developed property.

Although potentially beneficial to the lender and the borrower, the use of interest reserves carries certain risks. Of particular concern is the possibility that an interest reserve may not accurately reflect problems with a borrower’s willingness or ability to repay the debt consistent with the terms and conditions of the loan obligation. For example, a project that is not completed in a timely manner or falters once completed may appear to perform if the interest reserve keeps the loan current. In some cases, a lender may extend, renew, or restructure the term of certain loans, providing additional interest reserves to keep the loan current. As a result, the financial condition of the project may not be apparent and developing problems may not be addressed in a timely manner. Consequently, a lender may have a matured loan where the interest reserve has been fully advanced, and the borrower’s financial condition has deteriorated. In addition, the project may not be complete, its sale or lease-up may not be sufficient to ensure timely repayment of the debt or the value of the collateral may have declined, exposing the lender to increasing credit losses. At June 30, 2013, the Company had $8.6 million of performing loans with interest reserves.

Liquidity and Capital Resources

The Company’s 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, federal funds sold, and U.S. Government agency and other marketable investment securities. The Bank also has the ability to borrow funds from the Federal Reserve Bank and the Federal Home Loan Bank of Atlanta (“FHLB”) and to purchase federal funds from other financial institutions. The Company sold $12.0 million aggregate principal amount of subordinated promissory notes to certain accredited investors between May and August 2009. These notes are due ten years after the date of issuance, beginning May 15, 2019, and the Company is obligated to pay interest at an annualized rate of 8.5% payable in quarterly installments beginning on the third month anniversary of the date of issuance. The Company may prepay the notes at any time after the fifth anniversary of the date of issuance, subject to compliance with applicable law. Management believes that the Bank’s liquidity sources are adequate to meet its operating needs and the operating needs of the Bank for the next eighteen months. Total shareholders’ equity was $22.3 million or 2.7% of total assets at June 30, 2013 and $22.7 million or 2.6% of total assets at December 31, 2012. Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $16.0 million. As of June 30, 2013, the Bank has the credit capacity to borrow up to $165.8 million, from the FHLB, with $112.0 million outstanding as of June 30, 2013 and December 31, 2012.

The Company had total risk based capital of 10.82%, Tier 1 risk based capital of 6.38%, and leverage ratio of 3.68% at June 30, 2013, as compared to 10.17%, 5.93% and 3.33%, respectively, at December 31, 2012.

The Bank had total risk based capital of 10.95%, Tier 1 risk based capital of 9.68%, and leverage ratio of 5.58% at June 30, 2013, as compared to 10.20%, 8.93%, and 5.01%, respectively, at December 31, 2012. At June 30, 2013 the Bank is well capitalized.

The Company is currently prohibited by the Written Agreement from paying interest on its subordinated promissory notes and on its subordinated debentures in connection with its trust preferred securities ("TPS") without prior approval of the supervisory authorities. The Company and the Bank are prohibited from declaring or paying dividends without prior approval of the supervisory authorities. The Company obtained approval to pay the interest on its subordinated promissory notes for every quarter when approval was required.The Company exercised its right to defer regularly scheduled interest payments on its outstanding TPS and as of June 30, 2013, $598,000 of interest payments have been accrued for and deferred pursuant to the terms of the indenture governing the TPS. The Company may not pay any cash dividends on its Common Stock until it is current on interest payments on such TPS. The Company has not paid any cash dividends on its Common Stock since it suspended dividends in the fourth quarter of 2010. As a bank holding company, the Company’s ability to declare and pay dividends also depends on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends.

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Book value per share at June 30, 2013 and 2012 was $2.80 and $3.95, respectively. Tangible book value per share (shareholders' equity less other intangibles), at June 30, 2013 was $2.80 as compared to $3.91 at June 30, 2012. In addition to the traditional capital measure, management uses tangible book value, which is a non-GAAP financial measure, to evaluate the adequacy of shareholders' equity and to facilitate comparisons with peers. The following table presents this non-GAAP financial measure and provides a reconciliation of this non-GAAP measure to the most directly comparable GAAP measure reported in the Company's consolidated financial statements at June 30, 2013 and 2012.



	June 30, 2013		June 30, 2012
	(amounts in thousands, except per share data)
Total shareholders' equity	$	22,264	$	30,658
Less: other intangibles	2		278
Net tangible book value	$	22,262	$	30,380

Number of shares outstanding	7,940,718		7,766,247

Tangible book value	$	2.80	$	3.91
Book value	$	2.80	$	3.95

The Company and the Bank are committed to improving our financial position and target capital levels to maintain a “well capitalized” status under federal banking agencies' guidelines. Management continues to evaluate various alternatives to increase tangible common equity and regulatory capital through the issuance of additional equity. The Company is also working to reduce its balance sheet to improve capital ratios and is actively evaluating a number of capital sources, asset reductions, and other balance sheet management strategies to ensure that the projected level of regulatory capital can support its balance sheet long-term. There can be no assurance that the Company will be successful in any efforts to raise additional capital.

Forward-looking Information

Information set forth in this Quarterly Report on Form 10-Q, under the caption “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 (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which statements represent the Company’s judgment concerning the future and are subject to risks and uncertainties that could cause its 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, our ability to comply with the Written Agreement, 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, our ability to raise capital and continue as a going concern, the failure of assumptions underlying the establishment of the allowance for possible loan losses, our ability to maintain an effective internal control environment, the low trading volume of our common stock and other considerations described in connection with specific forward-looking statements and other cautionary elements specified in the Company's periodic filings with the Securities and Exchange Commission (the "Commission"), including without limitation, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K.

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 4 – CONTROLS AND PROCEDURES

As required by paragraph (b) of Rule 13a-15 under the Exchange Act, an evaluation was carried out under the supervision and with the participation of the Company's management, including 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

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Act) as of the end of the period covered by this Quarterly Report. 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 Quarterly Report, the Company's disclosure controls and procedures are effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods required by the Commission's rules and forms and is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

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 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this Quarterly Report that the Company believes have materially affected or are reasonably likely to materially affect, its internal control over financial reporting.

Part II. OTHER INFORMATION

ITEM 1 – LEGAL PROCEEDINGS

There have been no material developments in the description of material legal proceedings as reported in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2012.

ITEM 1A - RISK FACTORS

Other than as set forth below there have been no material changes in the Company’s risk factors from those disclosed in its Annual Report on Form 10-K for the year ended December 31, 2012.

Pending Department of Justice matters could adversely affect us.

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ITEM 6 - EXHIBITS

The following exhibits are filed as part of this Quarterly Report on Form 10-Q.



Exhibit No.	Description

3.1	Articles of Amendment to Articles of Incorporation

31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101	The following materials from Four Oak Fincorp, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 formatted in XBRL (eXtensible Business Reporting Language) and furnished electronically herewith: (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Operations; (iii) Consolidated Statements of Comprehensive Income (Loss); (iv) Consolidated Statement of Shareholders’ Equity; (v) Consolidated Statements of Cash Flows; and (vi) Notes to Consolidated Financial Statements. *

* Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files in Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act, are deemed not filed for purposes of Section 18 of the Exchange Act, and otherwise are not subject to liability under those sections.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



		FOUR OAKS FINCORP, INC.


Date:	August 14, 2013	By:	/s/ Ayden R. Lee, Jr.
		Ayden R. Lee, Jr.
		Chairman, President and
		Chief Executive Officer

Date:	August 14, 2013	By:	/s/ Nancy S. Wise
		Nancy S. Wise
		Executive Vice President and
		Chief Financial Officer

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Exhibit Index



Exhibit No.	Description

3.1	Articles of Amendment to Articles of Incorporation

31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101	The following materials from Four Oak Fincorp, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2013 formatted in XBRL (eXtensible Business Reporting Language) and furnished electronically herewith: (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Operations; (iii) Consolidated Statements of Comprehensive Income (Loss); (iv) Consolidated Statement of Shareholders’ Equity; (v) Consolidated Statements of Cash Flows; and (vi) Notes to Consolidated Financial Statements. *

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