FOFN 09.30.2013 10Q

10-Q 1 fofn0930201310q.htm 10-Q FOFN 09.30.2013 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 September 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,	7,959,515
par value $1.00 per share	(Number of shares outstanding
(Title of Class)	November 12, 2013

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TABLE OF CONTENTS		Page No.

Part I.	FINANCIAL INFORMATION

Item 1 -	Financial Statements

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

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

	Consolidated Statements of Comprehensive Loss (Unaudited)
	Three and Nine Months Ended September 30, 2013 and 2012	5

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

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

	Notes to Consolidated Financial Statements (Unaudited)	8

Item 2 -	Managements' Discussion and Analysis of Financial Condition and Results of Operations	39

Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	49

Item 4 -	Controls and Procedures	49

Part II.	OTHER INFORMATION

Item 1 -	Legal Proceedings	50

Item 1A-	Risk Factors	50

Item 6 -	Exhibits	51

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Part I. FINANCIAL INFORMATION

Item 1 – FINANCIAL STATEMENTS

FOUR OAKS FINCORP, INC.

CONSOLIDATED BALANCE SHEETS



	September 30, 2013			December 31,
	(Unaudited)			2012^(*)
	(amounts in thousands, except share data)
ASSETS
Cash and due from banks	$	12,059		$	18,862
Interest-earning deposits	118,113			164,288
Cash and cash equivalents	130,172			183,150
CDs held for investment	35,035			26,460
Investment securities available for sale, at fair value	8,821			73,722
Investment securities held to maturity, at amortized cost	102,173			20,329
Total investment securities	110,994			94,051
Loans held for sale	214			19,297
Loans	495,989			497,929
Allowance for loan losses	(12,296		)	(16,549		)
Net loans	483,693			481,380
Accrued interest receivable	1,570			1,869
Bank premises and equipment held for sale, net	—			1,901
Bank premises and equipment, net	12,834			13,382
FHLB stock	6,076			6,415
Investment in life insurance	14,325			14,139
Foreclosed assets	10,443			15,136
Other assets	6,208			8,318
Total assets	$	811,564		$	865,498
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand	$	214,918		$	189,048
Money market, NOW accounts and savings accounts	160,342			164,614
Time deposits, $100,000 and over	166,336			215,984
Other time deposits	104,784			130,210
Total deposits	646,380			699,856
Borrowings	112,000			112,000
Subordinated debentures	12,372			12,372
Subordinated promissory notes	12,000			12,000
Accrued interest payable	1,609			1,736
Other liabilities	4,954			4,858
Total liabilities	789,315			842,822
Commitments (Note B)
Shareholders’ equity:
Common stock, $1.00 par value, 80,000,000 shares authorized; 7,959,514 shares issued and outstanding at September 30, 2013 and 7,815,315 shares issued and outstanding at December 31, 2012	7,960			7,815
Additional paid-in capital	34,262			34,192
Accumulated deficit	(19,988		)	(20,040		)
Accumulated other comprehensive income	15			709
Total shareholders' equity	22,249			22,676
Total liabilities and shareholders' equity	$	811,564		$	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					Nine Months Ended
	September 30,					September 30,
	2013		2012			2013		2012
	(amounts in thousands, except share data)
Interest and dividend income:
Loans, including fees	$	6,827	$	7,654		$	20,608	$	23,981
Investment securities:
Taxable	443		417			918		1,384
Dividends	78		68			263		223
Interest-earning deposits and Federal funds sold	164		163			498		460
Total interest and dividend income	7,512		8,302			22,287		26,048
Interest expense:
Deposits	846		1,561			2,693		5,296
Borrowings	1,025		1,029			3,041		3,056
Subordinated debentures	51		57			153		173
Subordinated promissory notes	257		260			763		776
Total interest expense	2,179		2,907			6,650		9,301
Net interest income	5,333		5,395			15,637		16,747
Provision for loan losses	—		2,089			35		1,803
Net interest income after provision for loan losses	5,333		3,306			15,602		14,944
Non-interest income:
Service charges on deposit accounts	458		508			1,333		1,440
Other service charges, commissions and fees	947		661			2,577		1,962
Gains on sale of investment securities available for sale	92		349			462		1,006
Total other-than-temporary impairment loss	—		—			—		(56		)
Portion of loss recognized in other comprehensive income	—		—			—		56
Net impairment loss recognized in earnings	—		—			—		—
Income from investment in life insurance	49		78			186		246
Other non-interest income	80		267			858		387
Total non-interest income	1,626		1,863			5,416		5,041
Non-interest expenses:
Salaries	2,435		2,560			7,749		7,652
Employee benefits	384		467			1,384		1,455
Occupancy expenses	250		335			903		995
Equipment expenses	354		340			1,059		1,108
Professional and consulting fees	903		622			2,309		1,915
FDIC assessments	371		527			1,290		1,645
Foreclosed asset-related costs, net	697		870			1,637		1,963
Collection expenses	234		290			925		1,288
Other	1,252		1,319			3,710		3,720
Total non-interest expenses	6,880		7,330			20,966		21,741
Income (loss) before income taxes	79		(2,161		)	52		(1,756		)
Provision for income taxes	—		—			—		(175		)
Net Income (loss)	$	79	$	(2,161	)	$	52	$	(1,581	)
Basic net income (loss) per common share	$	0.01	$	(0.28	)	$	0.01	$	(0.20	)
Diluted net income (loss) per common share	$	0.01	$	(0.28	)	$	0.01	$	(0.20	)
Weighted Average Shares Outstanding, Basic	7,944,600		7,769,887			7,897,348		7,729,454
Weighted Average Shares Outstanding, Diluted	7,944,600		7,769,887			7,897,348		7,729,454

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

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FOUR OAKS FINCORP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (UNAUDITED)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013			2012			2013			2012
	(amounts in thousands)
Net income (loss)	$	79		$	(2,161	)	$	52		$	(1,581	)

Other comprehensive income (loss):
Securities available for sale:
Unrealized gains(losses) on securities available for sale	(154		)	709			(728		)	1,738
Tax benefit(expense)	59			(279		)	281			(681		)
Reclassification of gains recognized in net income	(92		)	(349		)	(462		)	(1,006		)
Tax benefit	35			135			178			388
Amortization of unrealized gains on investment securities transferred from available-for-sale to held-to-maturity	50			—			60			—
Tax expense	(19		)	—			(23		)	—
Portion of other-than-temporary loss recognized in other comprehensive income	—			—			—			(56		)
Tax benefit	—			—			—			22
Total other comprehensive income (loss)	(121		)	216			(694		)	405

Comprehensive loss	$	(42	)	$	(1,945	)	$	(642	)	$	(1,176	)

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 loss	—	—		—		(1,581		)	—		(1,581		)
Other comprehensive income	—	—		—		—			405		405
Issuance of common stock	122,131	123		76		—			—		199
Stock based compensation	—	—		50		—			—		50
BALANCE, SEPTEMBER 30, 2012	7,785,518	$	7,786	$	34,174	$	(14,652	)	$	1,457	$	28,765



	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 income	—	—		—		52			—			52
Other comprehensive loss	—	—		—		—			(694		)	(694		)
Issuance of common stock	144,129	145		50		—			—			195
Stock based compensation	—	—		20		—			—			20
BALANCE, SEPTEMBER 30, 2013	7,959,514	$	7,960	$	34,262	$	(19,988	)	$	15		$	22,249

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)



	Nine Months Ended
	September 30,
	2013			2012
	(amounts in thousands)
Cash flows from operating activities:
Net income (loss)	$	52		$	(1,581	)
Adjustments to reconcile net income (loss) to net cash provided by operations:
Provision for loan losses	35			1,803
Provision for depreciation and amortization	735			873
Net amortization of bond premiums and discounts	1,368			1,409
Stock based compensation	20			50
Gain on sale of investment securities	(462		)	(1,006		)
Gain on sale of branches	(586		)	—
Loss on sale of foreclosed assets, net	1			237
Valuation adjustment on foreclosed assets	1,207			1,726
Earnings on bank-owned life insurance	(186		)	(246		)
Proceeds from sale of mortgage loans held for sale	21,993			—
Originations of mortgage loans held for sale	(21,136		)	—
Gain on sale of mortgage loans held for sale	(473		)	—
Changes in assets and liabilities:
Other assets	2,174			1,720
Accrued interest receivable	299			120
Other liabilities	96			1,441
Accrued interest payable	(127		)	262
Net cash provided by operating activities	5,010			6,808
Cash flows from investing activities:
Proceeds from sales and calls of investment securities available for sale	20,874			37,937
Proceeds from paydowns of investment securities available for sale	5,610			9,314
Proceeds from paydowns of investment securities held to maturity	8,604			3,454
Purchases of investment securities available for sale	(29,253		)	(36,273		)
Purchases of investment securities held to maturity	(24,660		)	(5,319		)
Net cash from sale of branches	(39,622		)	—
Purchases of CDs held for investment	(8,575		)	—
Redemption of FHLB stock	339			138
Net (increase) decrease in loans outstanding	(666		)	47,346
Purchases of bank premises and equipment	(161		)	(336		)
Proceeds from sales of foreclosed assets	5,429			4,043
Net recoveries (expenditures) on foreclosed assets	13			(13		)
Net cash (used in) provided by investing activities	(62,068		)	60,291
Cash flows from financing activities:
Net (decrease) increase in deposit accounts	3,885			(10,245		)
Proceeds from issuance of common stock	195			199
Net cash (used in) provided by financing activities	4,080			(10,046		)
Net (decrease) increase in cash and cash equivalents	(52,978		)	57,053
Cash and cash equivalents at beginning of period	183,150			164,966
Cash and cash equivalents at end of period	$	130,172		$	222,019

Supplemental disclosures of cash flow information:
Interest paid on deposits and borrowings	$	(6,777	)	$	(9,039	)
Supplemental disclosure for sale of branches:
Proceeds from sale of fixed assets	$	1,875		$	—
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	$	(694	)	$	405
Transfers of loans to foreclosed assets	$	1,957		$	8,481
Loans transferred from held for sale to held for investment	$	3,639		$	—
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 nine months ended September 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 nine months ended September 30, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2013.

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 and a decrease in the specific reserve on individual impaired loans resulted in a small provision for loan losses for the nine months ended September 30, 2013. The year-to-date net charge offs at September 30, 2013 decreased from the amount reported in the prior year to date period. Nonperforming assets continue to be elevated, although balances are less for nonperforming assets at September 30, 2013 as compared to December 31, 2012. Initiatives by the Special Assets Department are expected to continue to resolve nonperforming loans by either returning them to performing status or removing them from the Company's books. Management expects some additional losses to result from this team's efforts as the process for moving these assets continues. 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 income for the nine months ended September 30, 2013 was $52,000 compared to a net loss of $1,581,000 for the same period of 2012. In comparing the nine months ended September 30, 2013 and 2012, there was a decrease in the provision for loan losses of $1,768,000. An improvement in net charge-offs and a decrease in loan balances requiring reserves led to a loan loss provision in the amount of $35,000 for the nine months ended September 30, 2013 compared to a provision for loan losses of $1,803,000 for the same period in 2012. Net charge offs for the first nine months of 2013 were $4.3 million and $6.0 million for the comparable period in 2012. The historically low level of provision is attributed to improvements in problem loans and in the credit oversight processes, as well as fewer loans outstanding. For more detail on the changes to the Allowance for Loan and Lease Losses and provision, refer to Note E Loans and "Managements' Discussion and Analysis of Financial Condition and Results of Operations" in Part I, Item 2 of this report.

At September 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 10.57%, 6.32%, and 3.68%, respectively, compared to 10.17%, 5.93% and 3.33%, respectively, at December 31, 2012. At September 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 10.84%, 9.58% and 5.58%, respectively, compared to 10.20%, 8.93%, and 5.01%, respectively, at December 31, 2012.

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FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

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 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 September 30, 2013 were approximately $130.2 million. 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 September 30, 2013.



	September 30, 2013
	(amounts in thousands)
Commitments to extend credit	$	37,891
Undisbursed lines of credit	18,326
Financial stand-by letters of credit	343
Performance stand-by letters of credit	1,809
Legally binding commitments	58,369

Unused credit card lines	13,696

Total	$	72,065

On May 20, 2013, the U.S. Department of Justice (the “DOJ”) 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 has responded to the subpoena and continues to cooperate with the government’s investigation. No proceedings related to this investigation have been instituted against the Bank. Were the DOJ to bring any such proceedings, such proceedings would likely be civil in nature, seeking injunctive relief and monetary relief under the Financial Institutions Reform, Recovery and Enforcement Act.

In October 2013, multiple putative class action lawsuits were filed in United States district courts across the country against a number of different banks based on the banks’ alleged role in “payday lending.” Four of these lawsuits, pending in the Northern District of Georgia, the Middle District of North Carolina, the District of Maryland, and the Southern District of Florida, name the Bank as one of the defendants. The lawsuits allege that, by processing Automatic Clearing House transactions indirectly on behalf of “payday” lenders, the Bank is illegally participating in an enterprise to collect unlawful debts and is therefore liable to plaintiffs for damages under the federal Racketeer Influenced and Corrupt Organizations Act. The lawsuits also allege a variety of state law claims. The Bank has not yet responded to any of the complaints filed in these actions.

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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		Nine Months Ended
	September 30,		September 30,
	2013	2012	2013	2012
Weighted average number of common shares used in computing basic net income (loss) per common share	7,944,600	7,769,887	7,897,348	7,729,454
Effect of dilutive stock options	—	—	—	—
Weighted average number of common shares and dilutive potential common shares used in computing diluted net income (loss) per common share	7,944,600	7,769,887	7,897,348	7,729,454

For the three and nine month periods ended September 30, 2013 and 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 September 30, 2013 and 2012, there were 303,980 and 277,289 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 September 30, 2013 and December 31, 2012 are as follows:



	September 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Available for Sale:	(amounts in thousands)
Taxable municipal securities	$	3,971	$	—	$	148	$	3,823
Mortgage-backed securities
GNMA	3,860		—		15		3,845
Trust preferred securities	1,175		—		150		1,025
Equity securities	98		30		—		128
Total	$	9,104	$	30	$	313	$	8,821



	September 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Securities Held to Maturity:	(amounts in thousands)
Taxable municipal securities	$	3,648	$	142	$	—	$	3,790
Mortgage-backed securities
GNMA	93,787		474		1,508		92,753
FNMA	4,738		15		—		4,753
Total	$	102,173	$	631	$	1,508	$	101,296



	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 and mortgage-backed 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 September 30, 2013 and December 31, 2012. At December 31, 2012 there were no unrealized losses in the held to maturity category.



	September 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:
Taxable municipal securities	$	3,823	$	148					$	3,823	$	148
Mortgage-backed securities - GNMA	$	3,845	$	15	$	—	$	—	$	3,845	$	15
Total temporarily impaired securities	$	7,668	$	163	$	—	$	—	$	7,668	$	163

Other than temporary impairment
Trust preferred securities	$	—	$	—	$	1,025	$	150	$	1,025	$	150
Total other than temporarily impaired securities	$	—	$	—	$	1,025	$	150	$	1,025	$	150



	September 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	$	55,208	$	1,508	$	—	$	—	$	55,208	$	1,508
FNMA	—		—		—		—		—		—
Total temporarily impaired securities	$	55,208	$	1,508	$	—	$	—	$	55,208	$	1,508

-12-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	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
Equity securities	—		—		2		1		2		1
Total temporarily impaired securities	$	7,130	$	19	$	2	$	1	$	7,132	$	20

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

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 September 30, 2013, the unrealized losses relate to 26 mortgage backed securities, 4 taxable municipal 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, 2011 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 issuers of the trust preferred securities and has determined that based on the their current financial condition the unrealized losses as of September 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 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 September 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 September 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	—		—
Due after ten years	3,971		3,823
Total taxable municipal securities	3,971		3,823

Mortgage-backed securities - GNMA/FNMA:
Due within one year	—		—
Due after one year through five years	—		—
Due after five years through ten years	—		—
Due after ten years	3,860		3,845
Total mortgage-backed securities - GNMA/FNMA	3,860		3,845

Other securities:
Trust preferred securities	1,175		1,025
Equity securities	98		128
Total other securities	1,273		1,153

Total available for sale securities	$	9,104	$	8,821

	Held to Maturity
	Amortized Cost		Fair Value
	(amounts in thousands)
Taxable municipal securities:
Due within one year	—		—
Due after one year through five years	528		536
Due after five years through ten years	3,120		3,254
Due after ten years	—		—
Total taxable municipal securities	3,648		3,790

Mortgage-backed securities - GNMA/FNMA:
Due within one year	1,248		1,264
Due after one year through five years	64,388		64,421
Due after five years through ten years	31,684		30,618
Due after ten years	1,205		1,203
Total mortgage-backed securities - GNMA/FNMA	98,525		97,506

Total held to maturity securities	$	102,173	$	101,296

Securities with a carrying value of approximately $90.7 million and $93.2 million at September 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 nine months ended September 30, 2013 and 2012 were $20.9 million and $37.9 million, respectively. For the nine months ended September 30, 2013 and 2012 we recognized gross realized gains of $462,000 and $1.0 million, and gross losses of $0, respectively.

Sales and calls of securities available for sale and equity securities during the three months ended September 30, 2013 and 2012 were $8.0 million and $10.7 million, respectively. For the three months ended September 30, 2013 and 2012 generated gross realized gains were $92,000 and $349,000 and gross losses of $0, respectively.

-14-

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.

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 could render a second lien position to be effectively unsecured. Additional risks include lien perfection inaccuracies and disputes

-15-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

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 September 30, 2013 and December 31, 2012 are summarized as follows:



	September 30, 2013			December 31, 2012
	(amounts in thousands)
Commercial and industrial loans	$	27,286		$	29,563
Commercial construction and land development	70,227			90,899
Commercial real estate	197,858			181,194
Residential construction	27,144			20,445
Residential mortgage	163,890			165,009
Consumer	8,928			9,664
Other	1,085			1,278
Gross loans	496,418			498,052
Less:
Net deferred loan fees	(429		)	(123		)
Net loans before allowance	495,989			497,929
Allowance for loan losses	(12,296		)	(16,549		)

Total net loans	$	483,693		$	481,380

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



	September 30, 2013		December 31, 2012
	(amounts in thousands)
Loans past due ninety days or more and still accruing	$	25	$	32
Nonaccrual loans	33,873		35,970
Foreclosed assets	10,443		15,136
Total	$	44,341	$	51,138

-16-

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 nine months ended September 30, 2013 and 2012 and as of and for the twelve months ended December 31, 2012.



	Three Months Ended
	September 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 July 1, 2013	$	969		$	6,574		$	2,763		$	449	$	3,013		$	178		$	92		$	14,038

Provision for loan losses	(263		)	125			817			79		(718		)	(11		)	(29		)	—

Loans charged-off	(207		)	(1,485		)	(503		)	—		(259		)	(52		)	—			(2,506		)
Recoveries	175			318			11			—		211			49			—			764
Net (charge-offs) recoveries	(32		)	(1,167		)	(492		)	—		(48		)	(3		)	—			(1,742		)

Balance September 30, 2013	$	674		$	5,532		$	3,088		$	528	$	2,247		$	164		$	63		$	12,296

-17-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	Nine Months Ended
	September 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	(670		)	1,128			836			243			(1,553		)	58			(7		)	35

Loans charged-off	(267		)	(3,343		)	(1,728		)	(138		)	(1,164		)	(216		)	—			(6,856		)
Recoveries	426			496			1,019			—			493			134			—			2,568
Net (charge-offs) recoveries	159			(2,847		)	(709		)	(138		)	(671		)	(82		)	—			(4,288		)

Balance September 30, 2013	$	674		$	5,532		$	3,088		$	528		$	2,247		$	164		$	63		$	12,296

Ending Balance: individually evaluated for impairment	$	212		$	667		$	688		$	—		$	234		$	—		$	—		$	1,801

Ending Balance: collectively evaluated for impairment	$	462		$	4,865		$	2,400		$	528		$	2,013		$	164		$	63		$	10,495

Loans:
Ending balance	$	27,286		$	70,227		$	197,858		$	27,144		$	163,890		$	8,928		$	1,085		$	496,418
Less: ending Balance: individually evaluated for impairment	936			14,328			13,519			695			14,124			19			—			43,621
Ending balance: collectively evaluated for impairment	$	26,350		$	55,899		$	184,339		$	26,449		$	149,766		$	8,909		$	1,085		$	452,797



	Three Months Ended
	September 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 July 1, 2012	$	1,786		$	8,010		$	3,290		$	401		$	4,438		$	482		$	11	$	18,418

Provision for loan losses	(493		)	1,783			733			(108		)	103			16			55		2,089

Loans charged-off	(241		)	(2,580		)	(791		)	(1		)	(508		)	(75		)	—		(4,196		)
Recoveries	142			145			123			—			170			30					610
Net (charge-offs) recoveries	(99		)	(2,435		)	(668		)	(1		)	(338		)	(45		)	—		(3,586		)

Balance September 30, 2012	$	1,194		$	7,358		$	3,355		$	292		$	4,203		$	453		$	66	$	16,921

-18-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)



	Nine Months Ended
	September 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	(1,109		)	2,349			531			(412		)	83			324			37		1,803

Loans charged-off	(681		)	(4,735		)	(1,277		)	(36		)	(786		)	(405		)	—		(7,920		)
Recoveries	254			945			301			—			276			121			—		1,897
Net (charge-offs) recoveries	(427		)	(3,790		)	(976		)	(36		)	(510		)	(284		)	—		(6,023		)

Balance September 30, 2012	$	1,194		$	7,358		$	3,355		$	292		$	4,203		$	453		$	66	$	16,921

Ending Balance: individually evaluated for impairment	$	258		$	2,815		$	1,762		$	68		$	2,342		$	—		$	—	$	7,245

Ending Balance: collectively evaluated for impairment	$	936		$	4,543		$	1,593		$	224		$	1,861		$	453		$	66	$	9,676
Loans:
Ending balance	$	31,201		$	102,776		$	186,850		$	22,922		$	182,230		$	10,007		$	4,484	$	540,470
Less ending balance: individually evaluated for impairment	1,233			32,382			20,052			1,404			20,960			45			—		76,076
Ending balance: collectively evaluated for impairment	$	29,968		$	70,394		$	166,798		$	21,518		$	161,270		$	9,962		$	4,484	$	464,394

-19-

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

-20-

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.

-21-

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 September 30, 2013 and December 31, 2012.



	September 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	$	2,100	$	—	$	—	$	—	$	—	$	1,331	$	11	$	3,442
2 - Satisfactory Quality	580		344		2,299		4		12,374		254		16		15,871
3 - Satisfactory
- Merits Attention	9,745		15,257		70,418		3,016		57,023		3,959		816		160,234
4 - Low Satisfactory	12,448		33,874		109,955		22,781		69,362		1,078		113		249,611
5 - Special mention	196		3,600		2,558		162		7,519		69		129		14,233
6-8 - Substandard	1,035		17,152		12,628		1,181		17,612		61		—		49,669
	$	26,104	$	70,227	$	197,858	$	27,144	$	163,890	$	6,752	$	1,085	$	493,060



	September 30, 2013
	Consumer - Credit Card		Business- Credit Card
	(amounts in thousands)
Performing	$	2,156	$	1,177
Non Performing	20		5
Total	$	2,176	$	1,182

Total Loans			$	496,418



	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

-22-

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 September 30, 2013 and December 31, 2012.



	September 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	$	28	$	898	—	$	926	$	25,178	$	26,104	$	—
Commercial construction and land Development	757		13,747			14,504		55,723		70,227		—
Commercial real estate	471		7,529			8,000		189,858		197,858		—
Residential construction	—		695			695		26,449		27,144		—
Residential mortgage	779		10,985			11,764		152,126		163,890		—
Consumer	20		19			39		6,713		6,752		—
Consumer credit cards	74		20			94		2,082		2,176		20
Business credit cards	9		5			14		1,168		1,182		5
Other loans	—		—			—		1,085		1,085		—
Total	$	2,138	$	33,898		$	36,036	$	460,382	$	496,418	$	25



	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

-23-

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 Bank has various loans in the coastal region of North Carolina which are collateralized by properties and have seen declines in values which the Bank, at the present time, has no significant concentrations that pose a material risk that is in excess of 10% of total loans. 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 25.9% to $43.6 million at September 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, 2012 and September 30, 2013 resulted from approximately $4.3 million in charge offs, principal reductions of $5.9 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, $2.0 million in balances were transferred to foreclosed assets, $3.6 million were sold, and approximately $4.2 million of loans were newly classified as impaired during the reporting period.

-24-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

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



	September 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	$	393	$	432	$	—	$	421	$	2	$	449	$	10
Commercial construction and land development	12,273		19,364		—		13,400		15		14,797		73
Commercial real estate other	11,086		13,356		—		11,434		10		11,935		54
Residential construction	695		1,134		—		695		—		766		—
Residential mortgage	13,434		15,196		—		13,860		4		14,419		64
Consumer	19		29		—		20		—		24		—
Subtotal:	37,900		49,511		—		39,830		31		42,390		201

With an allowance recorded:
Commercial and industrial	$	543	$	759	$	212	$	695	$	—	$	778	$	4
Commercial construction and land development	2,055		2,929		667		2,062		3		2,123		12
Commercial real estate other	2,433		2,595		688		2,458		—		2,496		1
Residential construction	—		—		—		—		—		—		—
Residential mortgage	690		724		234		697		—		707		—
Consumer	—		—		—		—		—		—		—
Subtotal:	5,721		7,007		1,801		5,912		3		6,104		17

Totals:
Commercial	$	28,783	$	39,435	$	1,567	$	30,470	$	30	$	32,578	$	154
Consumer	19		29		—		20		—		24		—
Residential	14,819		17,054		234		15,252		4		15,892		64
Grand Total	$	43,621	$	56,518	$	1,801	$	45,742	$	34	$	48,494	$	218

-25-

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 September 30, 2013 and December 31, 2012.



	September 30, 2013		December 31, 2012
	(amounts in thousands)
Commercial & industrial	$	898	$	664
Commercial construction and land development	13,747		15,941
Commercial real estate	7,529		9,091
Residential construction	695		833
Residential mortgage	10,985		9,408
Consumer	19		33
Total	$	33,873	$	35,970

-26-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

Troubled Debt Restructurings

For the three and nine months ended September 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 September 30, 2013 and December 31, 2012 (amounts in thousands).



September 30, 2013:	Accrual		Nonaccrual		Total TDRs		Allowance for Loan Losses Allocated
Commercial & Industrial	$	38	$	337	$	375	$	25
Commercial Construction and Land Development	228		9,600		9,828		—
Commercial real estate	4,479		4,759		9,238		182
Residential mortgage	3,025		2,963		5,988		234
Consumer	—		3		3		—
Total modifications	$	7,770	$	17,662	$	25,432	$	441



December 31, 2012	Accrual		Nonaccrual		Total TDRs		Allowance for Loan Losses Allocated
Commercial & Industrial	$	349	$	87	$	436	$	45
Commercial Construction and Land Development	3,484		10,659		14,143		—
Commercial real estate	5,522		4,437		9,959		922
Residential mortgage	3,945		3,113		7,058		372
Total modifications	$	13,300	$	18,296	$	31,596	$	1,339

-27-

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 nine months ended September 30, 2013.



		Three Months Ended					Nine Months Ended
		September 30, 2013					September 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
	Residential mortgage	—	$	—	$	—	1	$	453	$	453
	Subtotal	—	—		—		1	453		453

Extended payment terms
	Commercial real estate	—	$	—	$	—	4	$	213	$	213
	Residential mortgage	1	58		58		4	249		249
	Subtotal	1	58		58		8	462		462
Other
	Commercial real estate	—	$	—	$	—	1	$	33	$	33

	Total	1	$	58	$	58	10	$	948	$	948

The table below details successes and failures of TDRs that we have entered into during the twelve months ended September 30, 2013. There have been ten TDRs executed during the previous 12 months, of which two resulted in default by the borrower, as $30,000 was accepted as settlement and the remainder of $200,000 was charged off. Notes totaling $796,000 are paying as agreed in the restructure, and notes totaling $58,000 were converted to non-accrual.



		For the 12 month period ended September 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	$	452	—	$	—	—	$	—
Extended payment terms		—	—		5	311		1	58		2	—
Forgiveness of principal		—	—		—	—		—	—		—	—
Other		—	—		1	33		—	—		—	—
	Total	—	$	—	7	$	796	1	$	58	2	$	—

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.

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

-28-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

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 third 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 September 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.

-29-

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 September 30, 2013 and December 31, 2012.



					Fair Value Measurements at
					September 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	9/30/2013		9/30/2013		(Level 1)		(Level 2)		(Level 3)
	(amounts in thousands)
Taxable municipal securities	$	3,823	$	3,823	$	—	$	3,823	$	—
Mortgage-backed securities
GNMA	3,845		3,845		—		3,845		—
FNMA	—		—		—		—		—
Trust preferred securities	1,025		1,025		—		—		1,025
Equity securities	128		128		50		78		—
Total available for sale securities	$	8,821	$	8,821	$	50	$	7,746	$	1,025



					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

-30-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

The following table presents the reconciliation for the three and nine months ended September 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 Nine Months Ended
	September 30,				September 30,
	Securities available-for-sale				Securities available-for-sale
	2013		2012		2013		2012
	(amounts in thousands)
Beginning Balance	$	1,019	$	1,019	$	1,006	$	1,085
Total realized and unrealized gains or (losses):
Included in earnings	—		—		—		—
Included in other comprehensive income (loss)	6		12		19		(54		)
Purchases, issuances and settlements	—		—		—		—
Transfers in (out) of Level 3	—		—		—		—
Ending Balance	$	1,025	$	1,031	$	1,025	$	1,031

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 September 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 $43.6 million at September 30, 2013. Of such loans, $5.7 million had specific loss allowances aggregating $1.8 million at that date for a net fair value of $3.9 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 September 30, 2013 (amounts in thousands, except percentages):



Total Carrying Amount
Nonrecurring measurements:
Impaired loans	$	3,920	Collateral discounts	15-70%
Foreclosed assets	$	10,443	Discounted appraisals	10-30%
Recurring measurements:
Trust preferred securities	$	1,025	Probability of default	10-20%
			Loss given default	100%

-31-

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 nine month period ended September 30, 2013, the Company recognized approximately $1.2 million in valuation reductions on foreclosed assets and the carrying value of foreclosed assets was $10.4 million at September 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 on a non-recurring basis at fair value at September 30, 2013 and December 31, 2012.



					Fair Value Measurements at
					September 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
	9/30/2013		9/30/2013		(Level 1)		(Level 2)		(Level 3)
	(amounts in thousands)
Impaired loans	$	3,920	$	3,920	$	—	$	—	$	3,920
Foreclosed assets	$	10,443	$	10,443	$	—	$	—	$	10,443



					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	$	18,371	$	18,371	$	—	$	—	$	18,371
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 carrying amounts for these assets approximate fair value because of the short maturities of those instruments.

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 September 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 September 30, 2013 and December 31, 2012.



	September 30, 2013
	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
Financial assets:	(amounts in thousands)
Cash and cash equivalents	$	130,172	$	130,172	$	130,172	$	—	$	—
CDs held for investment	$	35,035	$	35,035	$	—	$	35,035	$	—
Securities available for sale	$	8,821	$	8,821	$	50	$	7,746	$	1,025
Securities held to maturity	$	102,173	$	101,296	$	—	$	101,296	$	—
Loans held for sale	$	214	$	214	$	—	$	—	$	214
Loans, net	$	483,693	$	484,777	$	—	$	—	$	484,777
FHLB stock	$	6,076	$	6,076	$	—	$	6,076	$	—
Accrued interest receivable	$	1,570	$	1,570	$	—	$	1,570	$	—

Financial liabilities:
Deposits	$	646,380	$	632,240	$	—	$	632,240	$	—
Subordinated debentures and promissory notes	$	24,372	$	15,598	$	—	$	—	$	15,598
Borrowings	$	112,000	$	122,231	$	—	$	122,231	$	—
Accrued interest payable	$	1,609	$	1,609	$	—	$	1,609	$	—



	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 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 third quarter of 2013. The Company exercised its right to defer regularly scheduled interest payments on its outstanding TPS and as of September 30, 2013, $650,000 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 nine months ended September 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 September 30, 2013:	(amounts in thousands, except ratios)
Total Capital (to Risk Weighted Assets)	$	50,761	10.84	%	$	37,446	8.0	%	$	46,808	10.0	%
Tier I Capital (to Risk Weighted Assets)	44,821		9.58	%	18,723		4.0	%	28,085		6.0	%
Tier I Capital (to Average Assets)	44,821		5.58	%	32,143		4.0	%	40,179		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 September 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 10.57%, 6.32%, 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.

-36-

FOUR OAKS FINCORP, INC.

Notes to Consolidated Financial Statements - (Continued)

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.

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.

-37-

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.

-38-

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.

-39-

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

September 30, 2013 and December 31, 2012

The Company’s total assets declined $53.9 million during the nine month period ending September 30, 2013 or 6.23% from a balance at December 31, 2012 of $865.5 million to $811.6 million at September 30, 2013. Cash and cash equivalents decreased approximately $53.0 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 and investments in interest bearing certificates of deposits at other financial institutions. Gross loans declined $1.9 million due to payoffs, paydowns, and charge offs. Loans held for sale declined $19.1 million due to the closing of the First Bank sale on March 22, 2013. CDs held for investment increased $8.6 million and investment securities increased $16.9 million as cash was invested in higher yielding assets. The remaining changes in total assets were decreases in foreclosed assets of $4.7 million as sales outpaced additions, and a decline of $2.1 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 $53.5 million or 7.64% for the nine month period ended September 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.

Total shareholders’ equity declined from $22.7 million at December 31, 2012 to $22.2 million at September 30, 2013, primarily due to a decrease in accumulated other comprehensive income of $694,000 offset by net income of $52,000 and additional shares of common stock issued for the dividend reinvestment and employee stock purchase programs of $195,000, for the nine months ended September 30, 2013.

Results of Operations for the Three Months Ended

September 30, 2013 and 2012

Net Income (loss). Net income for the three months ended September 30, 2013 was $79,000, or $0.01 per basic and diluted share, as compared to net loss of $2.2 million, or $0.28 net loss per basic and diluted share, for the three months ended September 30, 2012. The $2.2 million increase in profits is primarily due to a $2.1 million decrease in the provision for loan losses and a decrease of $450,000 in non-interest expenses less a $237,000 decrease in non-interest income for the third quarter of 2013 as compared to 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.

-40-

Net interest income for the three months ended September 30, 2013 was $5.3 million, as compared to $5.4 million for the quarter ended September 30, 2012, a decrease of $0.1 million. The major reasons for the slight decline was a decrease in average interest-earning assets decreasing $98.8 million primarily due to a decrease in the average loan portfolio of $53.0 million, a decrease in interest bearing deposits with banks, partially offset by an increased average balance of investment securities of $6.3 million. Interest bearing liabilities decreased $116.8 million from the quarter ended September 30, 2012 and average rates paid on these deposits decreased 17 basis points from 1.68% to 1.51%. However, net interest margins increased 31 basis points from 2.46% to 2.77% for the quarter ended September 30, 2013 as compared to the quarter ended September 30, 2012.

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 $44.3 million at September 30, 2013 from $51.1 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 September 30, 2013, no provision for the allowance for loan losses was recognized in earnings compared to a provision of $2.1 million for the three months ended September 30, 2012. Net charge-offs as a percentage of average loans decreased 31 basis points, from 0.66% for the three month period ended September 30, 2012 to 0.35% for the three month period ended September 30, 2013. Non-accrual loans at September 30, 2013 were $33.9 million representing a decrease from $43.8 million at September 30, 2012, and from $36.0 million at December 31, 2012. The Company has various loans in the coastal region of North Carolina which was hit hard by the recession causing the property collateralizing loans in this region to decline in value. The Company has evaluated these loans in determining its allowance for loan losses as of September 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 September 30, 2013, impaired loans, which include non-accrual loans, troubled debt restructuring and other impaired notes, were $43.6 million. Of these loans, $5.7 million have specific loss allowances that aggregate $1.8 million. Impaired loan charge-offs, upgrades, and principal reductions have reduced the impaired loan population from $58.9 million at December 31, 2012 to $43.6 million at September 30, 2013 resulting in the reduction of reserves allocated to impaired loans during the period of $3.6 million. The reduction in impaired loan reserves was the primary driver for the decrease in our allowance for loan losses to 2.48% of gross loans at September 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 September 30, 2013 decreased to $1.6 million from $1.9 million for the same period ended September 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 $0.2 million in other non-interest income, representing the premiums on sale of the guaranteed portion of SBA loans, partially offset by an increase of $0.3 million in revenue from the mortgage origination division.

Non-Interest Expenses. Non-interest expense decreased to $6.9 million for the quarter ended September 30, 2013 as compared to $7.3 million for the quarter ended September 30, 2012. The decrease is primarily related to decreases in salaries and benefits of $0.2 million, collections expenses of $0.1 million, expenses related to the holding of foreclosed property of $0.2 million and a decrease in the FDIC premium of $0.2 million, which were partially offset by an increase in professional and consulting fees of $0.3 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 Nine Months Ended

September 30, 2013 and 2012

Net Income (loss). Net income for the nine months ended September 30, 2013 was $52,000, or $0.01 per basic and diluted share, as compared to net loss of $1.6 million, or a loss of $0.20 per basic and diluted share for the nine months ended September 30, 2012. The increase in profits of $1.6 million or $0.21 per basic and diluted share results primarily from a decrease in loan loss provisions of $1.8 million and a decrease of $775,000 in non-interest expense, which is offset by a decrease in net interest income of $1.1 million and a $375,000 increase in non-interest income.

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.

The Federal Reserve has kept the interest rates unchanged during 2012 and the first nine months of 2013. For the remainder of 2013, management anticipates continued pressure on net interest margins as earning asset yields will continue to compress, while the ability to manage deposits and funding costs lower will become more challenging.

Net interest income for the nine months ended September 30, 2013 was $15.6 million as compared to $16.7 million for the nine months ended September 30, 2012, a decrease of $1.1 million. 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 $569.8 million for the nine months ended September 30, 2012, compared to $495.2 million for the same period ended September 30, 2013. The average interest rate for investment securities declined 41 basis points from 1.60% for the nine months ending September 30, 2012, to 1.19%, for the same period ended September 30, 2013. Also time deposits decreased an average of $129.4 million, from an average of $429.0 million for the nine months ended September 30, 2012 to an average of $299.6 million for the same period in 2013. Additionally, the average rates for time deposits decreased 46 basis points, from 1.54% for the nine months ended September 30, 2012, to 1.08% for the same period in 2013. Net interest margin increased 34 basis points from 2.34% to 2.68% for the nine month period ended September 30, 2013 as compared to the same period ended September 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 September 30, 2013 was $12.3 million, which represents 2.48% of total loans outstanding compared to $16.5 million or 3.32% as of December 31, 2012. For the nine months ended September 30, 2013, net loan charge-offs were $4.3 million compared with $6.0 million for the nine months ended September 30, 2012, and non-accrual loans were $33.9 million and $36.0 million at September 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 $44.3 million at September 30, 2013 from $51.1 million at December 31, 2012. This decrease was primarily due to a decrease in nonaccrual loans of $2.1 million, and a decrease in foreclosed assets of $4.7 million. During the nine months ended September 30, 2013, a $35,000 provision was made for the allowance for loan losses compared to a $1.8 million provision for the nine months ended September 30, 2012. At September 30, 2013, impaired loans, which include non-accrual loans, troubled debt restructurings, and other impaired loans, totaled $43.6 million compared to $58.9 million at December 31, 2012. Of these loans,

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$5.7 million have specific reserves that aggregate to $1.8 million compared to $23.8 million with $5.4 million in specific reserves as of December 31, 2012, decreases of $18.0 million and $3.6 million, respectively. Our allowance for loan losses decreased to 2.48% of gross loans at September 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 at September 30, 2013.

Non-Interest Income. Non-interest income increased $0.4 million for the nine months ended September 30, 2013 to $5.4 million as compared to $5.0 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 $0.5 million, offset by a decrease in the gain on available for sale securities of $0.5 million.

Non-Interest Expenses. Non-interest expenses decreased $775,000 to $21.0 million for the nine months ended September 30, 2013 compared to $21.7 million for the nine months ended September 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 $326,000, a decrease in FDIC assessment premiums of $355,000, a reduction in collection expenses of $363,000 and reduced occupancy expense of $92,000, offset by increases in professional and consulting fees of $394,000.

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

Management is committed to a proactive nonaccrual and problem loan identification philosophy. This philosophy is implemented through the ongoing monitoring and review of all pools of risk in the loan portfolio to ensure that problem loans are identified quickly and the risk of loss minimized. The following table provides detailed information regarding nonperforming assets, and past due loans as of September 30, 2013 and December 31, 2012.



	September 30, 2013			December 31, 2012
Nonaccrual loans:	(amounts in thousands, except ratios)
Commercial and industrial	$	898		$	664
Commercial construction and land development	13,747			15,941
Commercial real estate	7,529			9,091
Residential construction	695			833
Residential mortgage	10,985			9,408
Consumer	19			33
Total nonaccrual loans	$	33,873		$	35,970

Foreclosed assets:
Commercial and industrial	$	50		$	71
Commercial construction and land development	6,453			8,363
Commercial real estate	3,066			2,420
Residential construction	90			602
Residential mortgage	784			3,680
Total foreclosed assets	$	10,443		$	15,136

Past due 90 days or more and still accruing:
Business credit cards	$	5		$	—
Consumer credit cards	20			32
Total past due 90 days and still accruing	$	25		$	32

Total nonperforming assets	$	44,341		$	51,138

Nonaccrual loans to gross loans	6.83		%	7.23		%
Nonperforming assets to total assets	5.46		%	5.91		%
Allowance coverage of nonperforming loans	36.27		%	45.97		%

Non-accrual loans as a percentage of gross loans has decreased to 6.83% as of September 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 36.27% as of September 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 $1.8 million as of September 30, 2013, compared to $5.4 million as of December 31, 2012, a 67% decrease. The allowance for loan losses on the loans reviewed collectively as part of the Bank's ASC 450 analysis has decreased from $11.2 million as of December 31, 2012 to $10.5 million as of September 30, 2013. The allowance for loan losses as a percentage of loans reviewed collectively has increased from 2.32% at December 31, 2012 to 2.54% at September 30, 2013 due primarily to improved charge-off trends.

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

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•	performance of an updated cash flow analysis

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 $0.1 million and $1.0 million at September 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 September 30, 2013 and December 31, 2012, respectively.

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



	September 30, 2013		December 31, 2012
Performing TDRs:	(amounts in thousands)
Commercial industrial	$	38	$	349
Commercial construction and land development	228		3,484
Commercial real estate	4,479		5,522
Residential mortgage	3,025		3,945
Total performing TDRs	$	7,770	$	13,300



	September 30, 2013		December 31, 2012
Nonperforming TDRs:	(amounts in thousands)
Commercial industrial	$	337	$	87
Commercial construction and land development	9,600		10,659
Commercial real estate	4,759		4,437
Residential mortgage	2,963		3,113
Consumer	3		—
Total nonperforming TDRs	$	17,662	$	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 September 30, 2013 there were 120 foreclosed properties valued at a total of $10.4 million and 224 nonaccrual loans totaling $33.9 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.

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The gross interest income that would have been recorded for non-performing loans for the nine months ended September 30, 2013 and September 30, 2012, was approximately $3.3 million and $4.7 million, respectively. The amount of interest recognized for performing TDRs during the first nine months of 2013 was approximately $0.2 million.

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



	September 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	$	674	5	%	$	1,185	7	%
Commercial construction and land development	5,531		46	%	7,251		44	%
Commercial real estate	3,087		25	%	2,961		18	%
Residential construction	528		4	%	423		3	%
Residential mortgage	2,249		18	%	4,471		27	%
Consumer	164		1	%	188		1	%
Other	63		1	%	70		—	%
Total	$	12,296	100	%	$	16,549	100	%

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



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013			2012			2013			2012
	(amounts in thousands)
Balance, beginning of period	$	14,038		$	18,418		$	16,549		$	21,141
Provision for loan losses	—			2,089			35			1,803
Allowance before net (charge-offs) recoveries	14,038			20,507			16,584			22,944

Loans charged-off	(2,506		)	(4,196		)	(6,855		)	(7,920		)
Recoveries	764			610			2,567			1,897
Net (charge-offs) recoveries	(1,742		)	(3,586		)	(4,288		)	(6,023		)

Balance, end of period	$	12,296		$	16,921		$	12,296		$	16,921

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



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013			2012			2013			2012
	(amounts in thousands, except ratios)
Balance at beginning of period	$	14,038		$	18,418		$	16,549		$	21,141

Charge-offs:
Commercial and industrial	207			230			250			637
Business credit cards	—			11			17			44
Commercial construction and land development	1,485			2,580			3,343			4,735
Commercial real estate	503			791			1,728			1,277
Residential construction	—			1			138			36
Residential mortgage	259			508			1,164			786
Consumer	42			74			146			388
Consumer credit card	10			1			70			17
Total charge-offs	2,506			4,196			6,856			7,920
Recoveries:
Commercial and industrial	175			140			417			252
Business credit cards	—			2			9			2
Commercial construction and land development	318			145			496			945
Commercial real estate	11			123			1,019			301
Residential construction	—			—			—			—
Residential mortgage	211			170			493			276
Consumer	48			29			129			115
Consumer credit card	1			1			5			6
Total recoveries	764			610			2,568			1,897

Net (charge-offs)	(1,742		)	(3,586		)	(4,288		)	(6,023		)

Provision for loan losses - increase	—			2,089			35			1,803

Balance at end of period	$	12,296		$	16,921		$	12,296		$	16,921

Ratio of net charge-offs during the period to average gross loans outstanding during the period	0.35		%	0.66		%	0.87		%	1.06		%

As the Company continues to work through problem loans, net charge-offs continue to improve as compared to 2012 levels, both for the three months and year-to-date.. The Bank added additional dedicated resources in 2012 to focus on the resolution of nonperforming assets which have contributed to the improved results at September 30, 2013.

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 September 30, 2013 approximately 92.5% 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 credit-worthiness of the borrower and guarantors and the protection provided by the real estate and other

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collateral. For the lender, an interest reserve may provide an effective means for addressing the cash flow characteristics of a properly 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 September 30, 2013, the Company had $7.1 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 for the next eighteen months. Total shareholders’ equity was $22.2 million or 2.7% of total assets at September 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 that remains unused at September 30, 2013. As of September 30, 2013, the Bank has the credit capacity to borrow up to $162.3 million, from the FHLB, as compared to $173.1 million at December 31, 2012, a decrease of $10.8 million as a result of a decrease in total assets as of September 30, 2013, with $112.0 million outstanding as of September 30, 2013 and December 31, 2012.

The Company had total risk based capital of 10.57%, Tier 1 risk based capital of 6.32%, and leverage ratio of 3.68% at September 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 10.84%, Tier 1 risk based capital of 9.58%, and leverage ratio of 5.58% at September 30, 2013, as compared to 10.20%, 8.93%, and 5.01%, respectively, at December 31, 2012. At September 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 September 30, 2013, $650,000 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 September 30, 2013 and December 31, 2012 was $2.80 and $2.90, respectively. Tangible book value per share (shareholders' equity less other intangibles), at September 30, 2013 was $2.80 as compared to $2.90 at December 31, 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 September 30, 2013 and December 31, 2012.



	September 30, 2013		December 31, 2012
	(amounts in thousands, except share and per share data)
Total shareholders' equity	$	22,249	$	22,676
Less: other intangibles	2		3
Net tangible book value	$	22,247	$	22,673

Number of shares outstanding	7,959,514		7,815,315

Tangible book value	$	2.80	$	2.90
Book value	$	2.80	$	2.90

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 manage 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 , 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 Act) as of the end of the period covered by this Quarterly Report. Based on their evaluation, the Chief Executive Officer and

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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

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.

On May 20, 2013, the DOJ 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 has responded to the subpoena and continues to cooperate with the government’s investigation. In order to eliminate the uncertainties and expense of the investigation and a potential lawsuit from the DOJ, the Bank initiated settlement discussions with the DOJ. Nothing in the settlement offer currently being discussed would constitute an admission of any wrongdoing, liability, or violation of law by the Bank. However, final negotiation and approval of a settlement will take time, and there can be no assurance that a definitive settlement agreement will be reached or that such settlement will receive required approval. The Bank cannot reasonably estimate its range of loss or liability, if any, related to this investigation and potential litigation because there are a number of unknown facts and unresolved legal issues that will impact the amount of the Bank’s potential liability.

Pending or future litigation could adversely affect our financial condition, results of operations and cash flows.

We are from time to time party to various legal actions in the course of our business and an adverse outcome in such litigation could adversely affect our business, financial condition and results of operations. Refer to Part II, Item 1, Legal Proceedings, of this Quarterly Report on Form 10-Q for further information regarding our litigation.

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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 (incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10Q for the period ended June 30, 2013)

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 September 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 Loss; (iv) Consolidated Statement of Shareholders’ Equity; (v) Consolidated Statements of Cash Flows; and (vi) Notes to Consolidated Financial Statements.

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

Date:	November 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 (incorporated by reference to Exhibit 3.1 to the Company's Quarterly Report on Form 10Q for the period ended June 30, 2013)

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 September 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 Loss; (iv) Consolidated Statement of Shareholders’ Equity; (v) Consolidated Statements of Cash Flows; and (vi) Notes to Consolidated Financial Statements.

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