EX-13 4 exhibit13.htm EXHIBIT (13)

exhibit13.htm

EXHIBIT (13)

APPENDIX A

PEOPLES BANCORP OF NORTH CAROLINA, INC.

General Description of Business

Peoples Bancorp of North Carolina, Inc. (the “Company”), was formed in 1999 to serve as the holding company for Peoples Bank (the “Bank”).  The Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”).  The Company’s principal source of income is any dividends, which are declared and paid by the Bank on its capital stock.  The Company has no operations and conducts no business of its own other than owning the Bank.  Accordingly, the discussion of the business which follows concerns the business conducted by the Bank, unless otherwise indicated.

The Bank, founded in 1912, is a state-chartered commercial bank serving the citizens and business interests of the Catawba Valley and surrounding communities through 19 banking offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory, Charlotte, Monroe and Cornelius, North Carolina.  The Bank also operates a loan production office in Denver, North Carolina.  In January 2008, the Bank opened a traditional banking office in Iredell County, in Mooresville, North Carolina and a Banco de la Gente office in Wake County, in Raleigh, North Carolina.  At December 31, 2007, the Company had total assets of $907.3 million, net loans of $713.2 million, deposits of $693.7 million, total securities of $127.4 million, and shareholders’ equity of $70.1 million.

The Bank has a diversified loan portfolio, with no foreign loans and few agricultural loans.  Real estate loans are predominately variable rate commercial property loans, which include residential development loans to commercial customers.  Commercial loans are spread throughout a variety of industries with no one particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio.  The majority of the Bank's deposit and loan customers are individuals and small to medium-sized businesses located in the Bank's market area.  The Bank’s loan portfolio also includes Individual Taxpayer Identification Number (ITIN) mortgage loans generated thorough the Bank’s Banco de le Gente offices.  Additional discussion of the Bank’s loan portfolio and sources of funds for loans can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-4 through A-25 of the Annual Report, which is included in this Form 10-K as Exhibit 13.

The operations of the Bank and depository institutions in general are significantly influenced by general economic conditions and by related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Commissioner of Banks (the "Commissioner").

At December 31, 2007, the Bank employed 264 full-time equivalent employees.

The Bank is a subsidiary of the Company.  The Bank has two subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. Through a relationship with Raymond James Financial Services, Inc., Peoples Investment Services, Inc. provides the Bank's customers access to investment counseling and non-deposit investment products such as stocks, bonds, mutual funds, tax deferred annuities, and related brokerage services.  Real Estate Advisory Services, Inc., provides real estate appraisal and real estate brokerage services.

In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used in December 2006 to repay the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments.  The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

A-1

This report contains certain forward-looking statements with respect to the financial condition, results of operations and business of Peoples Bancorp of North Carolina, Inc. (the “Company”).  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on the information available to management at the time that these disclosures were prepared. These statements can be identified by the use of words like “expect,” “anticipate,” “estimate” and “believe,” variations of these words and other similar expressions.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank (the “Bank”), (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission.  The Company undertakes no obligation to update any forward-looking statements.

A-2

SELECTED FINANCIAL DATA
Dollars in Thousands Except Per Share Amounts
		2007				2006				2005				2004				2003
Summary of Operations
Interest income		$	61,732				55,393				41,913				35,095				33,799
Interest expense			27,585				23,110				15,429				12,335				12,749
Net interest income			34,147				32,283				26,484				22,760				21,050
Provision for loan losses			2,038				2,513				3,110				3,256				6,744
Net interest income after provision for loan losses			32,109				29,770				23,374				19,504				14,306
Non-interest income			8,816				7,554				6,668				6,000				5,825
Non-interest expense			25,993				22,983				20,330				18,840				17,072
Income before taxes			14,932				14,341				9,712				6,664				3,059
Income taxes			5,340				5,170				3,381				2,233				1,055
Net income		$	9,592				9,171				6,331				4,431				2,004
Selected Year-End Balances
Assets		$	907,262				818,948				730,280				686,348				674,032
Available for sale securities			120,968				117,581				115,158				105,598				79,460
Loans, net			713,174				643,078				559,239				527,419				542,404
Mortgage loans held for sale			-				-				2,248				3,783				587
Interest-earning assets			853,878				780,082				692,835				653,111				639,934
Deposits			693,639				633,820				582,854				556,522				549,802
Interest-bearing liabilities			718,870				650,364				576,681				553,135				550,357
Shareholders' equity		$	70,102				62,835				54,353				50,938				48,554
Shares outstanding*			5,624,234				5,745,951				5,677,328				5,689,763				5,690,392
Selected Average Balances
Assets		$	846,836				772,585				706,843				684,385				661,077
Available for sale securities			120,296				118,137				108,690				93,770				72,072
Loans			665,379				604,427				550,545				547,753				539,559
Interest-earning assets			801,094				732,244				668,614				650,528				626,197
Deposits			659,174				605,407				570,997				558,142				533,703
Interest-bearing liabilities			665,727				613,686				563,210				553,880				540,676
Shareholders' equity		$	70,586				62,465				55,989				51,978				49,971
Shares outstanding*			5,700,860				5,701,829				5,692,290				5,707,975				5,687,642
Profitability Ratios
Return on average total assets			1.13	%			1.19	%			0.90	%			0.65	%			0.30	%
Return on average shareholders' equity			13.59	%			14.68	%			11.31	%			8.52	%			4.01	%
Dividend payout ratio			24.30	%			20.78	%			22.34	%			28.37	%			62.56	%
Liquidity and Capital Ratios (averages)
Loan to deposit			100.94	%			99.84	%			96.42	%			98.14	%			101.10	%
Shareholders' equity to total assets			8.34	%			8.09	%			7.92	%			7.59	%			7.56	%
Per share of common stock*
Basic net income		$	1.68				1.61				1.11				0.77				0.35
Diluted net income		$	1.65				1.58				1.09				0.77				0.35
Cash dividends		$	0.41				0.33				0.25				0.22				0.22
Book value		$	12.46				10.94				9.57				8.95				8.53
*Shares outstanding and per share computations have been retroactively restated to reflect a 10% stock dividend during first quarter 2005, a 10% stock dividend during second quarter 2006 and a 3-for-2 stock split during second quarter 2007.

A-3

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-27  through A-56.

Introduction

Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company, for the years ended December 31, 2007, 2006 and 2005.  The Company is a registered bank holding company operating under the supervision of the Federal Reserve Board and the parent company of Peoples Bank (the “Bank”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell and Union Counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview

Our business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), inflation, interest rates, market and monetary fluctuations.  Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered.  Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and small businesses and (2) commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Company qualified as an accelerated filer in accordance with Rule 12b-2 of the Securities Exchange Act of 1934, effective December 31, 2006.  Therefore, the Company is subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”).  The Company incurred additional consulting and audit expenses in becoming compliant with SOX 404, and will continue to incur additional audit expenses to comply with SOX 404 going forward.  Management does not expect expenses related to SOX 404 to have a material impact on the Company’s financial statements.

The Bank opened a new office in Mecklenburg County, in Cornelius, North Carolina in June 2007and a new office in Iredell County, in Mooresville, North Carolina in January 2008.  Also in January 2008, the Bank opened a new Banco de la Gente office in Wake County, in Raleigh, North Carolina in a continuing effort to serve the Latino community.  While there are no additional traditional offices planned in 2008, management will consider opening at least one new traditional office in Mecklenburg or Iredell counties in the next two to three years and additional Banco de la Gente offices in other metropolitan areas in North Carolina.

A-4

Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with its wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance.  The following is a summary of some of the more subjective and complex accounting policies of the Company.  A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2007 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008 Annual Meeting of Shareholders.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability.  The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses.  The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability.  In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements.  Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques.  The Company’s internal models generally involve present value of cash flow techniques.  The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the Notes to Consolidated Financial Statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards.  These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133).  For a more complete discussion of policies, see the notes to consolidated financial statements.

In June 2006, FASB issued Financial Interpretation No. 48 (“FIN 48”) “Accounting for Uncertainty in Income Taxes – an interpretation of SFAS No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements and prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return.  This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  This interpretation was effective for the Company beginning in January of 2007.  The Company assessed the impact of FIN 48 and determined that there are no significant positions taken in the preparation of its tax return, and therefore FIN 48 did not have a material impact on its financial position or its results of operations.

In September 2006, the FASB ratified the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.”  This issue will require companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years.  EITF 06-4 is effective for the Company as of January 1, 2008.  This standard is not expected to have a material effect on the Company's financial position, results of operations or disclosures.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157).  SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.  SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements.  SFAS 157 is effective for the Company as of January 1, 2008.  This standard is not expected to have a material effect on the Company's financial position or results of operations.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158) – an amendment of FASB Statements No. 87, 88, 106 and 132(R).  SFAS 158 requires employers to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income.  SFAS 158 requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions and includes expanded disclosures.   SFAS 158 was effective for the Company as of January 1, 2007.  This standard did not have a material effect on the Company's financial position, results of operations or disclosures.

A-5

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159), which permits entities to choose to measure financial instruments and certain other instruments at fair value.  SFAS 159 is effective for the Company as of January 1, 2008.  The Company does not expect to choose this option for any asset or liability and therefore does not expect SFAS 159 to have a material effect on the Company's financial position, results of operations or disclosures.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with GAAP.  Actual results could differ from those estimates.

The remainder of management’s discussion and analysis of the Company’s results of operations and financial position should be read in conjunction with the consolidated financial statements and related notes presented on pages A-27 through A-56.

Results of Operations

Summary.  The Company reported earnings of $9.6 million in 2007, or $1.68 basic net earnings per share and $1.65 diluted net earnings per share, a 5% increase as compared to $9.2 million, or $1.61 basic net earnings per share and $1.58 diluted net earnings per share, for 2006. The Company’s increase in net earnings for 2007 is primarily attributable to growth in interest-earning assets, which contributed to increases in net interest income and an increase in non-interest income.  In addition, the Company had a decrease in the provision for loan losses for the year ended December 31, 2007 as compared to the same period one year ago.  The increases in net interest income and non-interest income and the decrease in the provision for loan losses were partially offset by an increase in non-interest expense.

Net earnings for 2006 represented an increase of 45% as compared to 2005 net earnings of $6.3 million or $1.11 basic net earnings per share and $1.09 diluted net earnings per share.  The increase in 2006 net earnings was primarily attributable to an increase in net interest income, an increase in non-interest income and a decrease in the provision for loan losses, which were partially offset by an increase in non-interest expense.

The return on average assets in 2007 was 1.13%, compared to 1.19% in 2006 and 0.90% in 2005. The return on average shareholders’ equity was 13.59% in 2007 compared to 14.68% in 2006 and 11.31% in 2005.

Net Interest Income.  Net interest income, the major component of the Company's net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them.  Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid.  Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.

Net interest income was $34.1 million for 2007, or 6% over net interest income of $32.3 million in 2006.  The increase was attributable to an increase in interest income due to an increase in the average outstanding balance of loans.  Net interest income increased 22% in 2006 from $26.5 million in 2005.

Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2007, 2006 and 2005. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on average total interest-earning assets for the same periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.  Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.

A-6

Table 1- Average Balance Table
		December 31, 2007										December 31, 2006										December 31, 2005
(Dollars in Thousands)		Average Balance			Interest			Yield / Rate				Average Balance			Interest			Yield /  Rate				Average Balance			Interest			Yield / Rate
Interest-earning assets:
Loans		$	665,379			55,109			8.28	%			604,427			49,665			8.22	%			550,545			37,234			6.76	%
Interest rate swap agreements			-			(406	)		-0.06	%			-			(698	)		-0.12	%			-			(575	)		-0.14	%
Loan fees			-			698			0.10	%			-			701			0.12	%			-			464			0.80	%
Total loans			665,379			55,401			8.33	%			604,427			49,668			8.22	%			550,545			37,123			6.74	%
Investments - taxable			20,305			868			4.27	%			29,784			1,306			4.38	%			37,487			1,595			4.25	%
Investments - nontaxable*			99,991			5,470			5.47	%			88,353			4,642			5.25	%			71,202			3,472			4.88	%
Federal funds sold			7,378			383			5.19	%			1,766			85			4.81	%			2,272			73			3.21	%
Other			8,041			444			5.52	%			7,914			424			5.36	%			7,108			269			3.61	%
Total interest-earning assets			801,094			62,566			7.81	%			732,244			56,125			7.66	%			668,614			42,532			6.36	%
Cash and due from banks			20,081										17,022										15,149
Other assets			34,287										31,218										30,891
Allowance for loan losses			(8,626	)									(7,899	)									(7,811	)
Total assets		$	846,836										772,585										706,843
Interest-bearing liabilities:
NOW accounts		$	79,550			1,127			1.42	%			87,329			1,214			1.39	%			110,852			1,468			1.32	%
Regular savings accounts			18,685			54			0.29	%			19,768			57			0.29	%			21,205			65			0.31	%
Money market accounts			87,916			2,918			3.32	%			66,035			1,789			2.71	%			56,858			1,112			1.96	%
Time deposits			361,859			17,430			4.82	%			335,092			14,189			4.23	%			292,807			8,923			3.05	%
FHLB borrowings			80,058			3,759			4.70	%			74,082			3,588			4.84	%			65,934			2,889			4.38	%
Demand notes payable to U.S. Treasury			814			39			4.79	%			722			34			4.71	%			702			21			3.02	%
Trust preferred securities			20,619			1,476			7.16	%			24,878			1,963			7.89	%			14,433			938			6.50	%
Other			16,226			782			4.82	%			5,780			276			4.78	%			419			13			3.00	%
Total interest-bearing liabilities			665,727			27,585			4.14	%			613,686			23,110			3.77	%			563,210			15,429			2.74	%
Demand deposits			111,164										97,183										89,275
Other liabilities			3,022										3,044										1,275
Shareholders' equity			70,586										62,465										55,989
Total liabilities and shareholder's equity		$	850,499										776,378										709,749
Net interest spread					$	34,981			3.67	%						33,015			3.89	%						27,103			3.62	%
Net yield on interest-earning assets									4.37	%									4.51	%									4.05	%
Taxable equivalent adjustment
Investment securities					$	834										731										619
Net interest income					$	34,147										32,284										26,484
*Includes U.S. government agency securities that are non-taxable for state income tax purposes of $74.9 million in 2007, $65.9 million in 2006 and $50.7 million in 2005. An effective tax rate of 6.90% was used to calculate the tax equivalent yield on these securities.

Changes in interest income and interest expense can result from variances in both volume and rates.  Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated.  The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.

A-7

Table 2 - Rate/Volume Analysis-Tax Equivalent Basis
		December 31, 2007				December 31, 2006
(Dollars in Thousands)		Changes in average volume	Changes in average rates	Total increase (decrease)		Changes in average volume	Changes in average rates	Total increase (decrease)
Interest income:

Loans: net of unearned income		$	5,042				691				5,733			$	4,030				8,515				12,545
Investments - taxable			(411	)			(27	)			(438	)			(333	)			44				(289	)
Investments - nontaxable			624				204				828				869				301				1,170
Federal funds sold			281				17				298				(20	)			32				12
Other			7				13				20				37				118				155
Total interest income			5,543				898				6,441				4,583				9,010				13,593
Interest expense:
NOW accounts			(109	)			22				(87	)			(320	)			66				(254	)
Regular savings accounts			(3	)			0				(3	)			(4	)			(4	)			(8	)
Money market accounts			660				469				1,129				214				463				677
Time deposits			1,211				2,030				3,241				1,540				3,726				5,266
FHLB borrowings			285				(114	)			171				375				324				699
Demand notes payable to
U.S. Treasury			4				1				5				1				12				13
Trust Preferred Securities			(320	)			(167	)			(487	)			752				273				1,025
Other			501				5				506				208				55				263
Total interest expense			2,229				2,246				4,475				2,766				4,915				7,681
Net interest income		$	3,314				(1,348	)			1,966			$	1,817				4,095				5,912

Net interest income on a tax equivalent basis totaled $35.0 million in 2007, increasing 6% or $2.0 million from 2006.  The increase was attributable to an increase interest income due to increases in the average outstanding balance of loans.  The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.67% in 2007, a decrease from the 2006 net interest spread of 3.89%.  The net yield on interest-earning assets in 2007 decreased to 4.37% from the 2006 net interest margin of 4.51%.

Tax equivalent interest income increased $6.4 million or 11% in 2007 primarily due to an increase in the Bank’s average outstanding balance of loans combined with an increase in the yield of interest-earning assets.  The yield on interest-earning assets increased to 7.81% in 2007 from 7.66% in 2006 as a result of a higher Prime Rate in effect for the first six months of 2007 being earned on higher loan balances plus an increase in the balance outstanding of higher yielding adjustable rate mortgage loans.  Average interest-earning assets increased $68.9 million primarily as the result of a $61.0 million increase in average loans. Average investment securities in 2007 increased 2% to $120.3 million when compared to 2006.  All other interest-earning assets including federal funds sold were $15.4 million in 2007 and $9.7 million in 2006.

Interest expense increased $4.5 million or 19% in 2007 due to an increase in the average rate paid on interest-bearing liabilities combined with a $52.0 million increase in volume of interest-bearing liabilities.   The cost of funds increased to 4.14% in 2007 from 3.77% in 2006.  This increase in the cost of funds was primarily attributable to increases in the average rate paid on interest-bearing checking and savings accounts and certificates of deposit.  The $52.0 million growth in average interest-bearing liabilities was primarily attributable to an increase in time deposits of $26.8 million to $361.9 million in 2007 from $335.1 million in 2006 and an increase in interest-bearing checking and savings accounts of $13.1 million to $186.2 million in 2007 from $173.1 million in 2006.

In 2006 net interest income on a tax equivalent basis increased $5.9 million or 22% to $33.0 million in 2006 from $27.1 million in 2005.  The interest rate spread was 3.89% in 2006, an increase from the 2005 net interest spread of 3.62%.  The net yield on interest-earning assets in 2006 increased to 4.51% from the 2005 net interest margin of 4.05%.

A-8

Provision for Loan Losses.  Provisions for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Company’s loan portfolio, including the valuation of impaired loans in accordance with SFAS No. 114 and No. 118, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.

The provision for loan losses was $2.0 million, $2.5 million, and $3.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.  The decrease in the provision for loan losses for 2007 is primarily attributable to a decrease in net charge-offs of $396,000 for the year ended December 31, 2007 when compared to the year ended December 31, 2006, offset by the effect of loan growth.  Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing potential loan losses.

Non-Interest Income.  Non-interest income for 2007 totaled $8.8 million, an increase of $1.2 million or 17% from non-interest income of $7.6 million for 2006.  The increases in non-interest income for 2007 are primarily due to an increase in service charges and fees resulting from growth in deposit base coupled with normal pricing changes, an increase in insurance and brokerage commissions, an increase in mortgage banking income and an increase in miscellaneous income.  Non-interest income for 2006 increased $886,000 or 13% from non-interest income of $6.7 million for 2005.  The increase in non-interest income for 2006 is primarily due to an increase in service charges and fees resulting from activity in new branches and an increase in miscellaneous income.

Service charges on deposit accounts totaled $4.3 million during 2007, an increase of $349,000, or 9% over 2006.  Service charge income increased $150,000, or 4% in 2006 compared to 2005.  These increases are primarily attributable to growth in the deposit base coupled with normal pricing changes, which resulted in an increase in account maintenance fees.

Other service charges and fees increased 26% to $1.9 million for the year ended December 31, 2007 as compared to $1.5 million for the same period one year ago.  This increase is primarily attributable to fee income from new branches.

The Company reported net losses on sale and writedown of securities of $562,000, $592,000 and $730,000 in 2007, 2006 and 2005, respectively.  The Company periodically evaluates its investments for any impairment which would be deemed other than temporary.   As part of its evaluation in 2007, the Company determined that the fair value of two investments was less than the original cost of the investments and that the decline in fair value was not temporary in nature.  As a result, the Company wrote down its original investment by $430,000.  The remaining value of the investments at December 31, 2007 is $348,000.  Losses on the sale of securities in 2006 and 2005 were primarily due to restructuring of the Bank’s investment portfolio to reduce exposure to a decrease in interest rates.

Mortgage banking income increased to $118,000 in 2007 from $108,000 in 2006 primarily due to an increase in brokered loan activity.  During 2006 mortgage banking income decreased $180,000 from the $469,000 reported in 2005.  The decrease in mortgage banking income for 2006 was primarily attributable to the $185,000 write-down of the Bank’s mortgage servicing asset due to Management’s assessment that there was minimal fair value in the mortgage servicing rights due to the small remaining balance in the loans serviced for others.

Net losses on repossessed assets were $118,000 for 2007 compared to net losses on repossessed assets of $108,000 for 2006.  During 2005 a net loss on repossessed assets of $38,000 was recognized.  The increase in net losses on repossessed assets during 2006 was primarily attributable to a $110,000 write-down on foreclosed property partially offset by a gain on the disposition of assets.  Management determined that the market value of these assets had decreased significantly and charges were appropriate during fourth quarter 2006.

Miscellaneous income for 2007 totaled $2.2 million, an increase of 4% from $2.1 million for 2006.  During 2006, miscellaneous income increased 27% primarily due to an increase in debit card fee income.  The 2006 increase in miscellaneous income was primarily attributable to an increase in debit card fee income primarily associated with increased card usage due to an increased number of demand accounts and income amounting to $118,000 distributed by a SBIC investment owned by the Bank.

A-9

Table 3 presents a summary of non-interest income for the years ended December 31, 2007, 2006 and 2005.

Table 3 - Non-Interest Income
(Dollars in Thousands)		2007				2006				2005
Service charges		$	4,279				3,930				3,780
Other service charges and fees			1,938				1,540				1,142
Gain (loss) on sale of securities			(562	)			(592	)			(730	)
Mortgage banking income			560				289				469
Insurance and brokerage commissions			521				389				387
Loss on foreclosed and repossessed assets			(118	)			(108	)			(38	)
Miscellaneous			2,198				2,106				1,658
Total non-interest income		$	8,816				7,554				6,668

Non-Interest Expense.  Total non-interest expense amounted to $26.0 million for 2007, an increase of 13% from 2006.  Non-interest expense for 2006 increased 13% to $23.0 million from non-interest expense of $20.3 million for 2005.

Salary and employee benefit expense was $13.9 million in 2007, compared to $11.8 million during 2006, an increase of $2.1 million or 18%, following a $921,000 or 8% increase in salary and employee benefit expense in 2006 over 2005.  The increase in salary and employee benefits in 2007 and 2006 is primarily due to normal salary increases and expense associated with additional staff for new branches.

The Company recorded occupancy expenses of $4.8 million in 2007, compared to $4.2 million during 2006, an increase of $571,000 or 14%, following an increase of $231,000 or 6% in occupancy expenses in 2006 over 2005.  The increases in 2007 and 2006 are primarily due to an increase in furniture and equipment expense and lease expense associated with new branches.  During 2003, the Company sold a branch location with net book value of approximately $2.4 million and was leasing the facility from the buyer.  As a result of the sale, the Company deferred a gain of approximately $633,000 and was recognizing the gain over the lease term.  For the period ended December 31, 2007 the Company recognized approximately $10,000 of the deferred gain and for the periods ended December 31, 2006 and 2005, respectively, approximately $21,000 and $22,000 of the deferred gain was recognized.  In 2007, the Company repurchased the branch location for $3.0 million, which was $588,000 greater than the original cost of the building.  The remaining deferred gain was netted against the purchase price resulting in a net cost of $2.5 million. This cost is being depreciated over 39 years.

The total of all other operating expenses increased $336,000 or 5% during 2007.  The increase in other expense for 2007 is primarily attributable to an increase of $215,000 in advertising expense.  Other operating expense increased $1.5 million or 27% in 2006 over 2005.  The increase in other expense for 2006 is primarily attributable to increases of $342,000 in consulting expenses due to Sarbanes-Oxley 404 compliance related expenses and disaster recovery planning expenses, and increase of $444,000 in amortization of the issuance costs of the trust preferred securities issued in 2001 that were called on December 31, 2006, an increase in $206,000 in debit card expense and an increase of $117,000 in advertising expense.

A-10

Table 4 presents a summary of non-interest expense for the years ended December 31, 2007, 2006 and 2005.

Table 4 - Non-Interest Expense
(Dollars in Thousands)		2007				2006				2005
Salaries and wages		$	10,276				9,368				7,162
Employee benefits			3,612				2,417				3,702
Total personnel expense			13,888				11,785				10,864
Occupancy expense			4,751				4,180				3,949
Office supplies			554				436				314
FDIC deposit insurance			140				75				76
Professional services			400				239				389
Postage			320				307				264
Telephone			405				338				403
Director fees and expense			499				423				334
Advertising			988				772				656
Consulting fees			460				575				233
Taxes and licenses			272				293				218
Other operating expense			3,316				3,560				2,630
Total non-interest expense		$	25,993				22,983				20,330

Income Taxes.  Total income tax expense was $5.3 million in 2007 compared with $5.2 million in 2006 and $3.4 million in 2005.   The primary reason for the increase in taxes for 2007 and 2006 as compared to 2005 was the increase in pretax income, which reduced the impact of non-taxable income. The Company’s effective tax rates were 35.76%, 36.05% and 34.81% in 2007, 2006 and 2005, respectively.

Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements.  Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities.  In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit.  As of December 31, 2007 such unfunded commitments to extend credit were $190.7 million, while commitments in the form of standby letters of credit totaled $3.9 million.

The Company uses several sources to meet its liquidity requirements.  The primary source is core deposits, which includes demand deposits, savings accounts and certificates of deposits of denominations less than $100,000.  The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships.  As of December 31, 2007, the Company’s core deposits totaled $490.1 million, or 71% of total deposits.

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased and FHLB advances.  The Bank is also able to borrow from the Federal Reserve on a short-term basis.

At December 31, 2007, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $53.9 million, which mature over the next two years.  The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits.   For additional information, please see the section below entitled “Deposits.”

The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $87.5 million at December 31, 2007.  The remaining availability at FHLB was $63.9 million at December 31, 2007.  The Bank also had the ability to borrow up to $35.0 million for the purchase of overnight federal funds from three correspondent financial institutions as of December 31, 2007.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 28.04% at December 31, 2007, 31.15% at December 31, 2006 and 36.81% at December 31, 2006.  The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.

A-11

As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $14.5 million during 2007.  Net cash used in investing activities of $80.6 million consisted primarily of a net increase in loans of $72.8 million.  Net cash provided by financing activities amounted to $74.4 million, primarily from $59.8 million net increase in deposits.

Asset Liability and Interest Rate Risk Management.  The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities.  This is done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 5 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2007.

Table 5 - Interest Sensitivity Analysis
(Dollars in Thousands)		Immediate				1-3 months				4-12 months				Total Within One Year				Over One Year & Non-sensitive				Total
Interest-earning assets:
Loans		$	481,495				4,941				13,170				499,606				222,671				722,277
Mortgage loans available for sale			-				-				-				-				-				-
Investment securities			-				8,881				-				8,881				112,087				120,968
Federal funds sold			2,152				-				-				2,152				-				2,152
Interest-bearing deposit accounts			1,539				-				-				1,539				-				1,539
Other interest-earning assets			-				-				-				-				6,942				6,942
Total interest-earning assets			485,186				13,822				13,170				512,178				341,700				853,878
Interest-bearing liabilities:
NOW, savings, and money market deposits			196,960				-				-				196,960				-				196,960
Time deposits			69,515				101,204				192,517				363,236				21,372				384,608
Other short term borrowings			1,600				-				-				1,600				-				1,600
FHLB borrowings			10,500				5,000				-				15,500				72,000				87,500
Securities sold under agreement to repurchase			27,583				-				-				27,583				-				27,583
Trust preferred securities			-				20,619				-				20,619				-				20,619
Total interest-bearing liabilities			306,158				126,823				192,517				625,498				93,372				718,870
Interest-sensitive gap		$	179,028				(113,001	)			(179,347	)			(113,320	)			248,328				135,008
Cumulative interest-sensitive gap		$	179,028				66,027				(113,320	)			(113,320	)			135,008
Interest-earning assets as a percentage of
interest-bearing liabilities			158.48	%			10.90	%			6.84	%			81.88	%			365.96	%

The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank.  The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company.  ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements.  The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year.  Rate sensitive assets therefore include both loans and available for sale securities.  Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds.  As shown in Table 5, the Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because most of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits.  During periods of rising rates, this results in increased net interest income.  The opposite occurs during periods of declining rates.  Rate sensitive assets at December 31, 2007 totaled $853.9 million, exceeding rate sensitive liabilities of $718.9 million by $135.0 million.

A-12

In order to assist in achieving a desired level of interest rate sensitivity, the Company entered into off-balance sheet contracts that are considered derivative financial instruments.  As of December 31, 2007, the Company had cash flow hedges with a notional amount of $185.0 million.  These derivative instruments consist of five interest rate floor contracts that are used to hedge future cash flows from payments on the first $185.0 million of certain variable rate loans against the downward effects of their repricing in the event of a decreasing rate environment for periods ending in July 2008, November 2008, January 2009, June 2009 and December 2009.  If the prime rate falls below 6.25% during the term of the contract on the first floor, the Company will receive payments based on the $35.0 million notional amount times the difference between 6.25% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 6.25% or higher.  The Company paid a premium of $161,000 on this contact.  On the second floor if the prime rate falls below 7.00% during the term of the contract, the Company will receive payments based on the $35.0 million notional amount times the difference between 7.00% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 7.00% or higher.  The Company paid a premium of $203,000 on this contract. On the third floor if the prime rate falls below 7.50% during the term of the contract, the Company will receive payments based on the $45.0 million notional amount times the difference between 7.50% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 7.50% or higher.  The Company paid a premium of $562,500 on this contract.  On the fourth floor if the prime rate falls below 8.00% during the term of the contract, the Company will receive payments based on the $35.0 million notional amount times the difference between 8.00% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 8.00% or higher.  The Company paid a premium of $399,000 on this contract.  On the fifth floor if the prime rate falls below 7.25% during the term of the contract, the Company will receive payments based on the $35.0 million notional amount times the difference between 7.25% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 7.25% or higher. The Company paid a premium of $634,000 on this contract.

           The Company recognized $47,000 in interest income from payments on interest rate floor contracts in 2007.   Based on the current interest rate environment, it is expected the Company will continue to receive income on these interest rate contracts in 2008.

Included in the rate sensitive assets are $471.6 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the FOMC.  The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate.  At December 31, 2007, the Bank had $75.6 million in loans with interest rate floors.  The floors were in effect on $27.7 million of these loans pursuant to the terms of the promissory notes on these loans.   The weighted average rate on these loans is 0.25% higher than the indexed rate on the promissory notes without interest rate floors.

The Bank also had $1.6 million in loans that are tied to the prime rate and had interest rate caps in effect pursuant to the terms of the promissory notes on these loans.  The weighted average rate on these loans is 0.47% lower than the indexed rate on the promissory notes without the interest rate caps.

An analysis of the Company’s financial condition and growth can be made by examining the changes and trends in interest-earning assets and interest-bearing liabilities.  A discussion of these changes and trends follows.

Analysis of Financial Condition

Investment Securities.  All of the Company’s investment securities are held in the available-for-sale (“AFS”) category. At December 31, 2007 the market value of AFS securities totaled $121.0 million, compared to $117.6 million and $115.2 million at December 31, 2006 and 2005, respectively.  The increase in 2007 investment securities is the result of net securities purchases that are part of management’s objective to grow the investment portfolio in an effort to manage the credit risk in the balance sheet.  This increase in AFS securities was partially offset by paydowns on mortgage-backed securities, calls and maturities.  Table 6 presents the market value of the AFS securities held at December 31, 2007, 2006 and 2005.

A-13

Table 6 - Summary of Investment Portfolio
(Dollars in Thousands)		2007				2006				2005
Obligations of United States government
agencies and corporations		$	76,992				72,744				60,243
Obligations of states and political subdivisions			25,905				24,366				21,609
Mortgage-backed securities			16,271				19,220				31,004
Trust preferred securities			250				750				1,750
Equity securities			1,550				501				552
Total securities		$	120,968				117,581				115,158

The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income.  The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.

The Company’s investment portfolio consists of U.S. government agency securities, municipal securities, U.S. government agency sponsored mortgage-backed securities, trust preferred securities and equity securities.  AFS securities averaged $120.3 million in 2007, $118.1 million in 2006 and $108.7 million in 2005.  Table 7 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2007.   Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields are calculated on a tax equivalent basis.  Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.

Table 7 - Maturity Distribution and Weighted Average Yield on Investments
								After One Year						After 5 Years
		One Year or Less						Through 5 Years						Through 10 Years						After 10 Years						Totals
(Dollars in Thousands)		Amount			Yield			Amount			Yield			Amount			Yield			Amount			Yield			Amount			Yield
Book value:
United States Government agencies		$	4,999			4.52%			45,249			4.93%			22,228			5.47%			2,679			6.08%			75,155			5.11%
States and political subdivisions			2,320			6.23%			11,173			4.76%			7,052			6.13%			5,311			6.58%			25,856			5.64%
Mortgage backed securities			-			-			673			4.55%			3,591			4.46%			12,206			4.71%			16,470			4.65%
Trust preferred securities			-			-			-			-			-			-			250			8.11%			250			8.11%
Equity securities			-			-			-			-			-			-			1,693			0.92%			1,693			0.92%
Total securities		$	7,319			5.06%			57,095			4.90%			32,871			5.50%			22,139			5.07%			119,424			5.10%

Loans.  The loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg and Union counties.  Although the Company  has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market.  Non-real estate loans also can be affected by local economic conditions.  

A-14

In management’s opinion, there are no significant concentrations of credit with particular borrowers engaged in similar activities.

Real estate mortgage loans include both commercial and residential mortgage loans.  At December 31, 2007, the Company had $94.8 million in residential mortgage loans, $79.3 million in home equity loans and $243.6 million in commercial mortgage loans, which include $195.1 million using commercial property as collateral and $48.5 million using residential property as collateral.

Residential mortgage loans include $36.9 million made to customers in the Company’s traditional banking offices and $57.9 million in mortgage loans originated in the Company’s Latino banking operations.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.   Also, the Company does not  have credit exposure for residential mortgage loans originated that are  not reflected in the Company’s assets and does not have any residential mortgage loans with a loan-to-value ratio in excess of 100%.

The mortgage loans originated in the traditional banking offices are generally 15 to 30 year fixed rate loans with attributes that cause the loans to not be sellable in the secondary market.  These factors may include higher loan-to-value ratio, limited documentation on income, non-conforming appraisal or non-conforming property type and are generally made to existing Bank customers.  These loans have been originated throughout the Company’s five county service area, with no geographic concentration.  At December 31, 2007 there were 14 loans with an outstanding balance of $2.0 million more than 30 days past due and no loans more than 90 days past due.

The mortgage loans originated in the Company’s Latino operations are primarily adjustable rate mortgage loans that adjust annually after the end of the first five years of the loan.  The loans are tied to the one-year T-Bill index and, if they were to adjust at 12/31/07, would have a reduction in the interest rate on the loan.  The underwriting on these loans includes both full income verification and no income verification, with loan-to-value ratios of up to 95% without private mortgage insurance.  A majority of these loans would be considered subprime loans, as they were underwritten using stated income rather than fully documented income verification.  No other loans in the Company’s portfolio would be considered subprime.  The majority of these loans have been originated within the Charlotte, NC metro area.  At this time, Charlotte has not experienced a decline in values within the residential real estate market.  At December 31, 2007 there were 46 loans with an outstanding balance of $4.9 million more than 30 days past due and no loans more than 90 days past due.  Total losses on this portfolio, since the first loans were originated in 2004 have amounted to approximately $15,000 through December 31, 2007.

The composition of the Company’s loan portfolio is presented in Table 8.

Table 8 - Loan Portfolio
		2007								2006								2005								2004								2003
(Dollars in Thousands)		Amount				% of Loans				Amount				% of Loans				Amount				% of Loans				Amount				% of Loans				Amount				% of Loans
Breakdown of loan receivables:
Commercial		$	82,190				11.38	%			85,064				13.06	%			79,902				14.10	%			79,189				14.79	%			90,558				16.41	%
Real estate - mortgage			417,709				57.83	%			364,595				55.97	%			330,227				58.28	%			312,988				58.45	%			332,730				60.26	%
Real estate - construction			209,644				29.03	%			187,960				28.86	%			141,420				24.96	%			127,042				23.73	%			110,392				19.99	%
Consumer			12,734				1.76	%			13,762				2.11	%			15,115				2.66	%			16,249				3.03	%			18,446				3.34	%
Total loans		$	722,277				100.00	%			651,381				100.00	%			566,664				100.00	%			535,468				100.00	%			552,126				100.00	%
Less: Allowance for loan losses			9,103								8,303								7,425								8,049								9,722
Net loans		$	713,174								643,078								559,239								527,419								542,404

As of December 31, 2007, gross loans outstanding were $722.3 million, an increase of $70.9 million or 11% from the December 31, 2006 balance of $651.4 million.  Commercial loans decreased $2.9 million in 2007.  Real estate mortgage loans grew $53.1 million when compared to 2006 due to an increase in non-conforming mortgage loans and commercial real estate loans. Real estate construction loans increased $21.7 million in 2007 as a result of an increase in real estate development loans.  Consumer loans decreased $1.0 million in 2007.

A-15

Table 9 identifies the maturities of all loans as of December 31, 2007 and addresses the sensitivity of these loans to changes in interest rates.

Table 9 - Maturity and Repricing Data for Loans
(Dollars in Thousands)		Within one year or less				After one year through five years				After five years				Total loans
Commercial		$	65,308				14,835				2,047				82,190
Real estate - mortgage			233,365				138,492				45,852				417,709
Real estate - construction			195,626				12,402				1,616				209,644
Consumer			5,307				6,544				883				12,734
Total loans		$	499,606				172,273				50,398				722,277
Total fixed rate loans		$	18,484				113,733				50,398				182,615
Total floating rate loans			481,122				58,540				-				539,662
Total loans		$	499,606				172,273				50,398				722,277

In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2007, outstanding loan commitments totaled $190.7 million.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Additional information regarding commitments is provided below in the section entitled “Contractual Obligations” and in Note 10 to the Consolidated Financial Statements.

Allowance for Loan Losses.  The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·   the Bank’s loan loss experience;

·   the amount of past due and non-performing loans;

·   specific known risks;

·   the status and amount of other past due and non-performing assets;

·   underlying estimated values of collateral securing loans;

·   current and anticipated economic conditions; and

·   other factors which management believes affect the allowance for potential credit losses.

Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of nine risk grades, each grade indicating a different level of loss reserves. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan as well as the level of reserves deemed appropriate for the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.

As an additional measure, the Bank engages an independent third party to review the underwriting, documentation, risk grading analyses and the methodology of determining the adequacy of the allowance for losses. This independent third party reviews and evaluates all loan relationships greater than $1.0 million.  The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.

A-16

Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.

Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment in accordance with SFAS No. 114, “Accounting By Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.  At December 31, 2007 and 2006, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $8.0 million and $7.6 million, respectively, with related allowance for loan losses of approximately $1.2 million for December 31, 2007 and 2006.

The general allowance reflects reserves established under the provisions of SFAS No. 5, “Accounting for Contingencies” for collective loan impairment.  These reserves are based upon historical net charge-offs using the last three years’ experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.

The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.

Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions that adversely affect the operating results of the Company.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2007 as compared to the year ended December 31, 2006. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.

Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.

Net charge-offs for 2007 were $1.2 million.  The ratio of net charge-offs to average total loans was 0.19% in 2007, 0.27% in 2006 and 0.68% in 2005.  Management expects the ratio of net charge-offs to average total loans in 2008 to be in a range similar to the ratios for 2007 and 2006.  The allowance for loan losses increased to $9.1 million or 1.26% of total loans outstanding at December 31, 2007.  For December 31, 2006 and 2005, the allowance for loan losses amounted to $8.3 million or 1.27% of total loans outstanding and $7.4 million, or 1.31% of total loans outstanding, respectively.

A-17

Table 10 presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at December 31, 2007 and 2006.

Table 10 - Loan Risk Grade Analysis
		Percentage of Loans
		By Risk Grade*
Risk Grade		2007	2006
Risk 1 (Excellent Quality)		11.06%	12.03%
Risk 2 (High Quality)		14.06%	14.89%
Risk 3 (Good Quality)		62.53%	60.31%
Risk 4 (Management Attention)		9.51%	10.46%
Risk 5 (Watch)		1.57%	0.41%
Risk 6 (Substandard)		0.13%	0.70%
Risk 7 (Low Substandard)		0.03%	0.02%
Risk 8 (Doubtful)		0.00%	0.00%
Risk 9 (Loss)		0.00%	0.00%
* Excludes non-accrual loans

Table 11 presents an analysis of the allowance for loan losses, including charge-off activity.

Table 11 - Analysis of Allowance for Loan Losses
(Dollars in Thousands)		2007				2006				2005				2004				2003
Reserve for loan losses at beginning		$	8,303				7,425				8,049				9,722				7,248
Loans charged off:
Commercial			414				505				293				1,004				1,179
Real estate - mortgage			471				568				2,141				3,842				2,422
Real estate - construction			252				250				1,250				4				251
Consumer			489				636				516				535				630
Total loans charged off			1,626				1,959				4,200				5,385				4,482
Recoveries of losses previously charged off:
Commercial			86				64				144				162				36
Real estate - mortgage			21				108				162				144				18
Real estate - construction			102				2				-				-				1
Consumer			179				150				160				150				157
Total recoveries			388				324				466				456				212
Net loans charged off			1,238				1,635				3,734				4,929				4,270
Provision for loan losses			2,038				2,513				3,110				3,256				6,744
Reserve for loan losses at end of year		$	9,103				8,303				7,425				8,049				9,722
Loans charged off net of recoveries, as
a percent of average loans outstanding			0.19	%			0.27	%			0.68	%			0.90	%			0.79	%

Non-performing Assets.  Non-performing assets, comprised of non-accrual loans, other real estate owned, other repossessed assets and loans for which payments are more than 90 days past due totaled $8.5 million at December 31, 2007 compared to $8.0 million at December 31, 2006.   Non-accrual loans were $8.0 million at December 31, 2007, an increase of $427,000 from non-accruals of $7.6 million at December 31, 2006.  As a percentage of loans outstanding, non-accrual loans were 1.11% and 1.16% at December 31, 2007 and 2006, respectively. The Bank had no loans 90 days past due and still accruing at December 31, 2007 as compared to $78,000 for the same period in 2006.  Other real estate owned totaled $483,000 and $344,000 as of December 31, 2007 and 2006, respectively.  The Bank had no repossessed assets as of December 31, 2007 and 2006.

A-18

At December 31, 2007 the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $8.0 million or 1.11% of total loans.  Non-performing loans for 2006 were $7.6 million, or 1.17% of total loans and $4.4 million, or 0.79% of total loans for 2005. Interest that would have been recorded on non-accrual loans for the years ended December 31, 2007, 2006 and 2005, had they performed in accordance with their original terms, amounted to approximately $693,000, $429,000 and $507,000, respectively. Interest income on impaired loans included in the results of operations for 2007, 2006, and 2005 amounted to approximately $29,000, $144,000 and $77,000, respectively.

Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing.  Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans.

It is the general policy of the Company to stop accruing interest income and place the recognition of interest on a cash basis when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed against current income.  Generally a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.

A summary of non-performing assets at December 31 for each of the years presented is shown in Table 12.

Table 12 - Non-performing Assets
(Dollars in Thousands)		2007				2006				2005				2004				2003
Non-accrual loans		$	7,987				7,560				3,492				5,097				4,343
Loans 90 days or more past due and still accruing			-				78				946				245				271
Total non-performing loans			7,987				7,638				4,438				5,342				4,614
All other real estate owned			483				344				531				682				1,447
All other repossessed assets			-				-				-				-				206
Total non-performing assets		$	8,470				7,982				4,969				6,024				6,267
As a percent of total loans at year end
Non-accrual loans			1.11	%			1.16	%			0.62	%			0.95	%			0.79	%
Loans 90 days or more past due and still accruing			0.00	%			0.01	%			0.17	%			0.05	%			0.05	%
Total non-performing assets			1.17	%			1.23	%			0.88	%			1.12	%			1.14	%

               Deposits.  The Company primarily uses deposits to fund its loan and investment portfolios. The Company offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits. As of December 31, 2007, total deposits were $693.6 million, an increase of $59.8 million or 9% increase over the December 31, 2006 balance of $633.8 million. Core deposits, which include demand deposits, savings accounts and certificates of deposits of denominations less than $100,000, increased to $490.1 million at December 31, 2007 from $439.6 million at December 31, 2006.

Time deposits in amounts of $100,000 or more totaled $203.5 million at December 31, 2007, $194.2 million and $152.4 million at December 31, 2006 and 2005, respectively.  At December 31, 2007, brokered deposits amounted to $53.9 million as compared to $60.0 million at December 31, 2006.  Brokered deposits are generally considered to be more susceptible to withdrawal as a result of interest rate changes and to be a less stable source of funds, as compared to deposits from the local market.  Brokered deposits outstanding as of December 31, 2007 have a weighted average rate of 5.06% with a weighted average original term of 7 months.

A-19

Table 13 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2007.

Table 13 - Maturities of Time Deposits over $100,000
(Dollars in Thousands)		2007
Three months or less		$	84,001
Over three months through six months			70,734
Over six months through twelve months			35,917
Over twelve months			12,848
Total		$	203,500

Borrowed Funds. The Company has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions.  At December 31, 2007, FHLB borrowings totaled $87.5 million compared to $89.3 million at December 31, 2006 and $71.6 million at December 31, 2005. Average FHLB borrowings for 2007 were $80.1 million, compared to average balances of $74.1 million for 2006 and $65.9 million for 2005. The maximum amount of outstanding FHLB borrowings was $95.0 million in 2007, and $99.5 in 2006 and $77.6 in 2005. The FHLB advances outstanding at December 31, 2007 had both fixed and adjustable interest rates ranging from 3.71% to 6.49%.  Currently $10.5 million of the FHLB advances outstanding have contractual maturities prior to December 31, 2008.  The FHLB has the option to convert $72.0 million of the total advances to a floating rate and, if converted, the Bank may repay advances without a prepayment fee.  The Company also has an additional $5.0 million in variable rate convertible advances, which may be repaid without a prepayment fee if converted by the FHLB.  Additional information regarding FHLB advances is provided in Note 6 to the Consolidated Financial Statements.

Demand notes payable to the U. S. Treasury, which represent treasury tax and loan payments received from customers, amounted to approximately $1.6 million at December 31, 2007 and 2006 and $1.5 million at December 31, 2005.

Securities sold under agreements to repurchase amounted to $27.6 million, $6.4 million and $981,000 as of December 31, 2007, 2006 and 2005, respectively.

Junior Subordinated Debentures (related to Trust Preferred Securities).  In June 2007 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2007 the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments.  The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

Contractual Obligations and Off-Balance Sheet Arrangements.  The Company’s contractual obligations and other commitments as of December 31, 2007 are summarized in Table 14 below.  The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements.  Other commitments include commitments to extend credit.  Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.

A-20

Table 14 - Contractual Obligations and Other Commitments
(Dollars in Thousands)		Within One Year				One to Three Years				Three to Five Years				Five Years or More				Total
Contractual Cash Obligations
Long-term borrowings*		$	-				7,000				5,000				65,000				77,000
Junior subordinated debentures			-				-				-				20,619				20,619
Operating lease obligations			897				1,381				863				2,149				5,290
Total		$	897				8,381				5,863				87,768				102,909
Other Commitments
Commitments to extend credit		$	62,838				40,706				5,160				81,950				190,654
Standby letters of credit
and financial guarantees written			3,792				102				-				-				3,894
Total		$	66,630				40,808				5,160				81,950				194,548
*Excludes $10.5 million adjustable rate credit due to the FHLB, which matured in February 2008.

The Company enters into derivative contracts to manage various financial risks.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date.  Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk.  Therefore, the derivative amounts recorded on the balance sheet do not represent the amounts that may ultimately be paid under these contracts.  Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-12 and in Notes 1, 10, 11 and 16 to the Consolidated Financial Statements.

Capital Resources.  Shareholders’ equity at December 31, 2007 was $70.1 million compared to $62.8 million at December 31, 2006 and $54.4 million at December 31, 2005.  Unrealized gains and losses, net of taxes, at December 31, 2007 amounted to a gain of $1.7 million.  At December 31, 2006 and 2005, unrealized gains and losses, net of taxes, amounted to losses of $771,000 and $1.4 million, respectively.  Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength.   Average shareholders’ equity as a percentage of total average assets was 8.34%, 8.09% and 7.92% for 2007, 2006 and 2005.   The return on average shareholders’ equity was 13.59% at December 31, 2007 as compared to 14.68% and 11.31% as of December 31, 2006 and December 31, 2005, respectively.  Total cash dividends paid during 2007 amounted to $2.3 million.  Cash dividends totaling $1.9 million and $1.4 million were paid during 2006 and 2005, respectively.

In November 2006, the Company’s Board of Directors authorized the repurchase of up to $2.0 million in common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of November 2007.  During 2007 the Company repurchased $1.9 million, or 100,000 shares, of its common stock under this plan.

In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008.  The Company has repurchased 50,497 shares, or $873,000, of its common stock under this plan as of December 31, 2007.

Under regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater.  Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill.  Tier 1 capital at December 31, 2007 and 2006 includes $20.0 million in trust preferred securities.  At December 31, 2005, Tier 1 capital includes $14.0 million in trust preferred securities.  The Company’s Tier 1 capital ratio was 11.03%, 11.70% and 11.02% at December 31, 2007, 2006 and 2005, respectively.  Total risk-based capital is defined as Tier 1 capital plus supplementary capital.  Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets.  The Company’s total risk-based capital ratio was 12.16%, 12.86% and 12.19% at December 31, 2007, 2006 and 2005, respectively.  In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to

A-21

total average assets of 4.0% or greater.  The Company’s Tier 1 leverage capital ratio was 10.43%, 10.80% and 9.84% at December 31, 2007, 2006 and 2005, respectively.

The Bank’s Tier 1 risk-based capital ratio was 9.80%, 10.21% and 10.46% at December 31, 2007, 2006 and 2005, respectively.  The total risk-based capital ratio for the Bank was 10.93%, 11.37% and 11.64% at December 31, 2007, 2006 and 2005, respectively.   The Bank’s Tier 1 leverage capital ratio was 9.26%, 9.41% and 9.33% at December 31, 2007, 2006 and 2005 respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater.  Based upon these guidelines, the Bank was considered to be "well capitalized" at December 31, 2007, 2006 and 2005.

The Company’s key equity ratios as of December 31, 2007, 2006 and 2005 are presented in Table 15.

Table 15 - Equity Ratios
		2007				2006				2005
Return on average assets			1.13	%			1.19	%			0.90	%
Return on average equity			13.59	%			14.68	%			11.31	%
Dividend payout ratio			24.30	%			20.78	%			22.34	%
Average equity to average assets			8.34	%			8.09	%			7.92	%

                Quarterly Financial Data.  The Company’s consolidated quarterly operating results for the years ended December 31, 2007 and 2006 are presented in Table 16.

Table 16 - Quarterly Financial Data
		2007																2006
(Dollars in thousands, except per share amounts)		First				Second				Third				Fourth				First				Second				Third				Fourth
Total interest income		$	15,200				15,446				15,625				15,461				12,484				13,559				14,390				14,961
Total interest expense			6,607				6,735				7,038				7,205				4,863				5,429				6,243				6,575
Net interest income			8,593				8,711				8,587				8,256				7,621				8,130				8,147				8,386
Provision for loan losses			323				634				296				785				759				413				686				655
Other income			2,122				2,139				2,007				2,548				1,929				2,017				2,043				1,564
Other expense			6,021				6,180				6,214				7,578				5,307				5,548				5,787				6,341
Income before income taxes			4,371				4,036				4,084				2,441				3,484				4,186				3,717				2,954
Income taxes			1,584				1,446				1,471				839				1,249				1,525				1,344				1,052
Net earnings		$	2,787				2,590				2,613				1,602				2,235				2,661				2,373				1,902
Basic earnings per share		$	0.49				0.45				0.46				0.28				0.39				0.47				0.42				0.33
Diluted earnings per share		$	0.48				0.44				0.45				0.28				0.38				0.46				0.41				0.33

A-22

QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates.  This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods.

The Company’s market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The structure of the Company’s loan and deposit portfolios is such that a significant decline (increase) in interest rates may adversely (positively) impact net market values and interest income. Management seeks to manage the risk through the utilization of its investment securities and off-balance sheet derivative instruments. During the years ended December 31, 2007, 2006 and 2005, the Company used interest rate contracts to manage market risk as discussed above in the section entitled “Asset Liability and Interest Rate Risk Management.”

Table 17 presents in tabular form the contractual balances and the estimated fair value of the Company’s on-balance sheet financial instruments and the notional amount and estimated fair value of the Company’s off-balance sheet derivative instruments at their expected maturity dates for the period ended December 31, 2007. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment at December 31, 2007.  As of December 31, 2007, all fixed rate advances are callable at the option of FHLB.  For core deposits without contractual maturity (i.e. interest bearing checking, savings, and money market accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff or repricing behaviors.

Table 17 - Market Risk Table
(Dollars In Thousands)		Principal/Notional Amount Maturing in Year Ended December 31,
Loans Receivable		2008			2009			2010			2011 & 2012			Thereafter			Total			Fair Value
Fixed rate		$	34,493			26,881			27,894			54,865			38,483			182,615			183,130
Average interest rate			7.41	%		7.53	%		7.39	%		7.65	%		7.64	%
Variable rate		$	206,001			75,033			51,738			54,833			152,058			539,662			539,662
Average interest rate			7.70	%		7.64	%		7.67	%		7.77	%		7.94	%
						-												722,277			722,792
Investment Securities			.
Interest bearing cash		$	-			-			-			-			1,539			1,539			1,539
Average interest rate			-			-			-			-			4.60	%
Federal funds sold		$	2,152			-			-			-			-			2,152			2,152
Average interest rate			4.10	%		-			-			-			-
Securities available for sale		$	24,240			28,056			17,799			38,646			12,226			120,968			120,968
Average interest rate			4.91	%		4.96	%		4.61	%		4.27	%		3.64	%
Nonmarketable equity securities		$	-			-			-			-			6,434			6,434			6,434
Average interest rate			-			-			-			-			5.74	%
Debt Obligations
Deposits		$	372,596			27,540			11,245			1,130			281,128			693,639			694,059
Average interest rate			4.02	%		4.12	%		4.20	%		3.88	%		1.58	%
Advances from FHLB		$	10,500			20,000			52,000			5,000			-			87,500			90,233
Average interest rate			4.40	%		4.41	%		4.71	%		4.21	%		-
Demand notes payable to U.S. Treasury		$	1,600			-			-			-			-			1,600			1,600
Average interest rate			3.27	%		-			-			-			-
Securities sold under agreement to repurchase		$	27,583			-			-			-			-			27,583			27,583
Average interest rate			4.15	%		-			-			-			-
Junior subordinated debentures		$	-			-			-			-			20,619			20,619			20,619
Average interest rate			-			-			-			-			6.62	%
Derivative Instruments (notional amount)
Interest rate floor contracts		$	70,000			115,000			-			-			-			185,000			1,907
Average interest rate			6.63	%		7.58	%		-			-			-

A-23

Table 18 presents the simulated impact to net interest income under varying interest rate scenarios and the theoretical impact of rate changes over a twelve-month period referred to as “rate ramps.”  The table shows the estimated theoretical impact on the Company’s tax equivalent net interest income from hypothetical rate changes of plus and minus 1% and 2% as compared to the estimated theoretical impact of rates remaining unchanged.  The table also shows the simulated impact to market value of equity under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks” of plus and minus 1% and 2% compared to the theoretical impact of rates remaining unchanged.  The prospective effects of the hypothetical interest rate changes are based upon various assumptions, including relative and estimated levels of key interest rates.  This type of modeling has limited usefulness because it does not allow for the strategies management would utilize in response to sudden and sustained rate changes.  Also, management does not believe that rate changes of the magnitude presented are likely in the forecast period presented.

Table 18 - Interest Rate Risk
(Dollars in thousands)
		Estimated Resulting Theoretical Net Interest Income
Hypothetical rate change (ramp over 12 months)		Amount			% Change
+2%		$	39,311		6.29%
+1%		$	38,037		2.85%
0%		$	36,983		0.00%
-1%		$	36,349		-1.72%
-2%		$	35,711		-3.44%
		Estimated Resulting Theoretical Market Value of Equity
Hypothetical rate change (immediate shock)		Amount			% Change
+2%		$	68,006		-7.82%
+1%		$	70,737		-4.11%
0%		$	73,772		0.00%
-1%		$	77,197		4.64%
-2%		$	81,030		9.84%

A-24

MARKET FOR THE COMPANY’S COMMON EQUITY

AND RELATED SHAREHOLDER MATTERS

Peoples Bancorp common stock is traded on the over-the-counter (OTC) market and quoted on the Nasdaq Global Market, under the symbol “PEBK.”   Scott and Stringfellow, Inc., Ryan, Beck & Co. and Sterne Agee & Leach, Inc. are market makers for the Company’s shares.

Although the payment of dividends by the Company is subject to certain requirements and limitations of North Carolina corporate law, neither the Commissioner nor the FDIC have promulgated any regulations specifically limiting the right of the Company to pay dividends and repurchase shares.  However, the ability of the Company to pay dividends and repurchase shares may be dependent upon the Company’s receipt of dividends from the Bank.  The Bank’s ability to pay dividends is limited.  North Carolina commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay.   Dividends may be paid by the Bank from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by North Carolina law.   Also, an insured depository institution, such as the Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is defined in the applicable law and regulations).   Based on its current financial condition, the Bank does not expect that this provision will have any impact on the Bank’s ability to pay dividends.

As of March 10, 2008, the Company had 700 shareholders of record, not including the number of persons or entities whose stock is held in nominee or street name through various brokerage firms or banks.   The market price for the Company’s common stock was $13.34 on March 10, 2008.

Table 19 presents certain market and dividend information for the last two fiscal years.  Over-the-counter quotations reflect inter-dealer prices, without retail mark-up, mark down or commission and may not necessarily represent actual transactions.

Table 19 - Market and Dividend Data
								Cash Dividend
2007		Low Bid			High Bid			Per Share
First Quarter		$	17.37			19.26			0.08
Second Quarter		$	17.89			21.15			0.09
Third Quarter		$	17.13			20.03			0.12
Fourth Quarter		$	14.75			18.00			0.12
								Cash Dividend
2006		Low Bid			High Bid			Per Share
First Quarter		$	13.37			16.37			0.07
Second Quarter		$	15.77			19.47			0.07
Third Quarter		$	16.18			19.47			0.07
Fourth Quarter		$	17.97			20.09			0.12

A-25

STOCK PERFORMANCE GRAPH

The following graph compares the Company’s cumulative shareholder return on its Common Stock with a NASDAQ index and with a southeastern bank index.  The graph was prepared by SNL Securities, L.C., Charlottesville, Virginia, using data as of December 31, 2007.

COMPARISON OF SIX-YEAR CUMULATIVE TOTAL RETURNS

Performance Report for

Peoples Bancorp of North Carolina, Inc.

A-26

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Financial Statements
December 31, 2007, 2006 and 2005
INDEX
	PAGE(S)
Management's Report on Internal Control Over Financial Reporting	A-28
Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements
and Internal Control Over Financial Reporting	A-29 - A-30
Financial Statements
Consolidated Balance Sheets at December 31, 2007 and December 31, 2006	A-31
Consolidated Statements of Earnings for the years ended December 31, 2007, 2006 and 2005	A-32
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2007, 2006 and 2005	A-33
Consolidated Statements of Comprehensive Income for the years ended December 31, 2007, 2006 and 2005	A-34
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005	A-35 - A-36
Notes to Consolidated Financial Statements	A-37 - A-56

A-27

MANAGEMENT’S REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting.  Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934.  The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.  Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and depositions of the assets of the company, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

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

Management assessed the effectiveness of the internal control over financial reporting as of December 31, 2007.  In making this assessment, management used the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  Based on our assessment and those criteria, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2007.

The Company’s independent registered public accountants have issued an audit report on our assessment of the company’s internal control over financial reporting.  Their report is included herein.

/s/ Tony W. Wolfe		/s/ A. Joseph Lampron
Tony W. Wolfe		A. Joseph Lampron
Chief Executive Officer		Chief Financial Officer
March 12, 2008		March 12, 2008

A-28

Porter Keadle Moore, LLP

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and shareholders

Peoples Bancorp of North Carolina, Inc.

Newton, North Carolina

We have audited the accompanying consolidated balance sheets of Peoples Bancorp of North Carolina, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of earnings, changes in shareholders’ equity, comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2007.  We have also audited the Company’s internal controls over financial reporting as of December 31, 2007, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report of Internal Controls Over Financial Reporting.  Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects.  Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  Our audits also include assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

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

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

A-29

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Peoples Bancorp of North Carolina, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, Peoples Bancorp of North Carolina, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ Porter Keadle Moore, LLP

Atlanta, Georgia

February 29, 2008

Certified Public Accountants  

____________________________________________________________________________________________________________________________________________

Suite 1800 Ÿ 235 Peachtree Street NE Ÿ  Atlanta, Georgia 30303 Ÿ Phone 404-588-4200  Ÿ Fax 404-588-4222  Ÿ www.pkm.com

A-30

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 2007 and 2006
Assets		2007				2006
Cash and due from banks, including reserve requirements		$	26,108,437				17,389,046
of $7,439,000 and $6,243,000
Interest bearing deposits			1,539,190				1,471,272
Federal funds sold			2,152,000				2,640,000
Cash and cash equivalents			29,799,627				21,500,318
Investment securities available for sale			120,968,358				117,581,000
Other investments			6,433,947				7,295,449
Total securities			127,402,305				124,876,449
Loans			722,276,948				651,381,129
Less allowance for loan losses			(9,103,058	)			(8,303,432	)
Net loans			713,173,890				643,077,697
Premises and equipment, net			18,234,393				12,816,385
Cash surrender value of life insurance			6,776,379				6,532,406
Accrued interest receivable and other assets			11,875,202				10,144,283
Total assets		$	907,261,796				818,947,538
Liabilities and Shareholders' Equity
Deposits:
Non-interest bearing demand		$	112,071,090				101,393,142
NOW, MMDA & savings			196,959,895				174,577,641
Time, $100,000 or more			203,499,504				194,176,291
Other time			181,108,214				163,673,215
Total deposits			693,638,703				633,820,289
Demand notes payable to U.S. Treasury			1,600,000				1,600,000
Securities sold under agreement to repurchase			27,583,263				6,417,803
FHLB borrowings			87,500,000				89,300,000
Junior subordinated debentures			20,619,000				20,619,000
Accrued interest payable and other liabilities			6,219,248				4,355,073
Total liabilities			837,160,214				756,112,165
Shareholders' equity:
Preferred stock, no par value; authorized
5,000,000 shares; no shares issued
and outstanding			-				-
Common stock, no par value; authorized
20,000,000 shares; issued and
outstanding 5,624,234 shares in 2007
and 3,830,634 shares in 2006			48,651,895				51,122,147
Retained earnings			19,741,876				12,484,463
Accumulated other comprehensive income (loss)			1,707,811				(771,237	)
Total shareholders' equity			70,101,582				62,835,373
Total liabilities and shareholders' equity		$	907,261,796				818,947,538
See accompanying notes to consolidated financial statements.

A-31

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
For the Years Ended December 31, 2007, 2006 and 2005
		2007				2006				2005
Interest income:
Interest and fees on loans		$	55,400,514				49,667,700				37,123,327
Interest on federal funds sold			383,492				85,307				72,578
Interest on investment securities:
U.S. Government agencies			4,571,571				4,321,346				3,584,755
States and political subdivisions			887,584				798,185				735,892
Other			488,465				521,077				396,020
Total interest income			61,731,626				55,393,615				41,912,572
Interest expense:
NOW, MMDA & savings deposits			4,098,892				3,060,201				2,644,413
Time deposits			17,430,012				14,188,623				8,923,488
FHLB borrowings			3,758,996				3,588,169				2,888,785
Junior subordinated debentures			1,475,701				1,962,692				938,145
Other			821,331				310,188				33,790
Total interest expense			27,584,932				23,109,873				15,428,621
Net interest income			34,146,694				32,283,742				26,483,951
Provision for loan losses			2,038,000				2,513,282				3,110,000
Net interest income after provision for loan losses			32,108,694				29,770,460				23,373,951
Other income:
Service charges			4,278,238				3,929,956				3,779,933
Other service charges and fees			1,938,137				1,539,367				1,141,879
Loss on sale and writedown of securities			(561,832	)			(591,856	)			(729,727	)
Mortgage banking income			560,291				289,293				469,109
Insurance and brokerage commissions			521,095				388,559				386,662
Loss on sale of repossessed assets			(117,880	)			(107,712	)			(37,811	)
Miscellaneous			2,197,645				2,106,188				1,658,189
Total other income			8,815,694				7,553,795				6,668,234
Other expense:
Salaries and employee benefits			13,887,841				11,785,094				10,863,779
Occupancy			4,750,634				4,180,058				3,948,694
Other			7,354,401				7,017,986				5,517,832
Total other expenses			25,992,876				22,983,138				20,330,305
Earnings before income taxes			14,931,512				14,341,117				9,711,880
Income taxes			5,339,541				5,170,300				3,380,900
Net earnings		$	9,591,971				9,170,817				6,330,980
Basic earnings per share		$	1.68				1.61				1.11
Diluted earnings per share		$	1.65				1.58				1.09
Cash dividends declared per share		$	0.41				0.33				0.25
See accompanying notes to consolidated financial statements.

A-32

PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Changes in Shareholders' Equity
For the Years Ended December 31, 2007, 2006 and 2005
														Accumulated
														Other
		Common Stock								Retained				Comprehensive
		Shares				Amount				Earnings				Income (Loss)				Total
Balance, December 31, 2004			3,135,074			$	35,040,390				16,018,206				(120,744	)			50,937,852
10% stock dividend			313,546				6,274,087				(6,274,087	)			-				-
Cash paid in lieu of fractional shares			-				-				(4,700	)			-				(4,700	)
Cash dividends declared			-				-				(1,414,239	)			-				(1,414,239	)
Repurchase and retirement of common
stock			(15,000	)			(314,750	)			-				-				(314,750	)
Exercise of stock options			7,185				96,773				-				-				96,773
Net earnings			-				-				6,330,980				-				6,330,980
Change in accumulated other
comprehensive income (loss), net of tax			-				-				-				(1,278,922	)			(1,278,922	)
Balance, December 31, 2005			3,440,805				41,096,500				14,656,160				(1,399,666	)			54,352,994
10% stock dividend			343,850				9,430,532				(9,430,532	)			-				-
Cash paid in lieu of fractional shares			-				-				(6,426	)			-				(6,426	)
Cash dividends declared			-				-				(1,905,556	)			-				(1,905,556	)
Repurchase and retirement of common
stock			(19,250	)			(425,000	)			-				-				(425,000	)
Exercise of stock options			65,229				771,325				-				-				771,325
Stock option tax benefit			-				243,100				-				-				243,100
Stock option compensation expense			-				5,690				-				-				5,690
Net earnings			-				-				9,170,817				-				9,170,817
Change in accumulated other
comprehensive income (loss), net of tax			-				-				-				628,429				628,429
Balance, December 31, 2006			3,830,634			$	51,122,147				12,484,463				(771,237	)			62,835,373
3 for 2 stock split			1,915,147				-				-				-				-
Cash paid in lieu of fractional shares			-				-				(3,355	)			-				(3,355	)
Cash dividends declared			-				-				(2,331,203	)			-				(2,331,203	)
Repurchase and retirement of common
stock			(150,497	)			(2,810,907	)			-				-				(2,810,907	)
Exercise of stock options			28,950				239,182				-				-				239,182
Stock option tax benefit			-				91,815				-				-				91,815
Stock option compensation expense			-				9,658				-				-				9,658
Net earnings			-				-				9,591,971				-				9,591,971
Change in accumulated other
comprehensive income (loss), net of tax			-				-				-				2,479,048				2,479,048
Balance, December 31, 2007			5,624,234			$	48,651,895				19,741,876				1,707,811				70,101,582
See accompanying notes to consolidated financial statements.

A-33

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
For the Years Ended December 31, 2007, 2006 and 2005
		2007				2006				2005
Net earnings		$	9,591,971				9,170,817				6,330,980
Other comprehensive income (loss):
Unrealized holding gains (losses) on securities
available for sale			1,964,861				197,569				(3,045,565	)
Reclassification adjustment for losses on
sales of securities available for sale included
in net earnings			561,832				591,856				729,727
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges			1,244,910				(345,049	)			(283,493	)
Reclassification adjustment for losses (gains) on
derivative financial instruments qualifying as
cash flow hedges included in net earnings			-				386,285				483,715
Total other comprehensive income (loss),
before income taxes			3,771,603				830,661				(2,115,616	)
Income tax expense (benefit) related to other
comprehensive income:
Unrealized holding gains (losses) on securities
available for sale			765,313				76,953				(1,186,248	)
Reclassification adjustment for losses on
sales of securities available for sale included
in net earnings			218,834				230,528				284,229
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges			308,408				(255,707	)			(123,082	)
Reclassification adjustment for losses (gains) on
derivative financial instruments qualifying as
cash flow hedges included in net earnings			-				150,458				188,407
Total income tax expense (benefit) related to
other comprehensive income			1,292,555				202,232				(836,694	)
Total other comprehensive income (loss),
net of tax			2,479,048				628,429				(1,278,922	)
Total comprehensive income		$	12,071,019				9,799,246				5,052,058
See accompanying notes to consolidated financial statements.

A-34

PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2007, 2006 and 2005
		2007				2006				2005
Cash flows from operating activities:
Net earnings		$	9,591,971				9,170,817				6,330,980
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Depreciation, amortization and accretion			1,553,251				1,616,558				1,643,459
Provision for loan losses			2,038,000				2,513,282				3,110,000
Deferred income taxes			(479,806	)			(615,626	)			332,806
Loss on sale and writedown of investment securities			561,832				591,856				729,727
Recognition of gain on sale of
derivative instruments			-				386,285				483,715
Amortization of deferred gain on sale of premises			(10,337	)			(20,896	)			(21,984	)
Loss (gain) on sale of repossessed assets			83,294				(2,288	)			(2,189	)
Writedown of other real estate and repossessions			34,586				110,000				40,000
Amortization of deferred issuance costs on
trust preferred securities			-				461,298				17,742
Stock option compensation expense			9,658				5,690				-
Change in:
Mortgage loans held for sale			-				2,247,900				1,535,275
Cash surrender value of life insurance			(243,973	)			(220,649	)			(277,569	)
Other assets			(1,013,866	)			(1,206,937	)			444,944
Other liabilities			2,403,990				(230,144	)			651,204
Net cash provided by operating activities			14,528,600				14,807,146				15,018,110
Cash flows from investing activities:
Purchases of investment securities available for sale			(15,858,155	)			(30,579,262	)			(49,431,813	)
Proceeds from calls and maturities of investment securities
available for sale			7,470,991				8,562,058				9,655,995
Proceeds from sales of investment securities available
for sale			8,362,525				19,871,979				27,768,392
Purchases of other investments			(8,356,900	)			(12,748,200	)			(5,367,790	)
Proceeds from sale of other investments			8,424,000				11,263,500				4,239,000
Net change in loans			(72,815,928	)			(86,825,349	)			(35,062,738	)
Purchases of premises and equipment			(7,672,018	)			(1,624,299	)			(1,373,019	)
Proceeds from sale of premises and equipment			55,630				-				1,750
Proceeds from sale of repossessed assets			425,158				825,115				246,218
Purchases of derivative financial instruments			(634,000	)			(961,500	)			(364,000	)
Payment on settlement of derivative
financial instruments			-				-				(870,000	)
Net cash used by investing activities			(80,598,697	)			(92,215,958	)			(50,558,005	)
Cash flows from financing activities:
Net change in deposits			59,818,414				50,966,628				26,331,588
Net change in demand notes payable to U.S. Treasury			-				126,307				289,301
Net change in securities sold under agreement to repurchase			21,165,460				5,436,753				981,050
Proceeds from FHLB borrowings			275,300,000				700,800,000				162,300,000
Repayments of FHLB borrowings			(277,100,000	)			(683,100,000	)			(149,700,000	)
Proceeds from issuance of trust preferred securities			-				20,619,000				-
Repayments of trust preferred securities			-				(14,433,000	)			-
Proceeds from exercise of stock options			330,997				1,014,425				96,773
Common stock repurchased			(2,810,907	)			(425,000	)			(314,750	)
Cash paid in lieu of fractional shares			(3,355	)			(6,426	)			(4,700	)
Cash dividends paid			(2,331,203	)			(1,905,556	)			(1,414,239	)
Net cash provided by financing activities			74,369,406				79,093,131				38,565,023
Net change in cash and cash equivalent			8,299,309				1,684,319				3,025,128
Cash and cash equivalents at beginning of period			21,500,318				19,815,999				16,790,871
Cash and cash equivalents at end of period		$	29,799,627				21,500,318				19,815,999

A-35

PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Cash Flows, continued
For the Years ended December 31, 2007, 2006 and 2005
		2007				2006				2005
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest		$	27,420,245				23,171,572				15,189,559
Income taxes		$	5,689,500				6,398,100				2,245,000
Noncash investing and financing activities:
Change in unrealized gain (loss) on investment securities
available for sale, net		$	1,542,546				481,944				(1,413,819	)
Change in unrealized gain on derivative financial
instruments, net		$	936,502				146,485				134,897
Transfer of loans to other real estate and repossessions		$	681,735				746,004				133,210
Financed portion of sale of other real estate		$	-				273,000				-
Reclassification of an investment from other assets
to securities available for sale		$	499,995				-				-
Reclassification of a security from other investments
to securities available for sale		$	600,000				-				715,000
Transfer of retained earnings to common stock for
issuance of stock dividend		$	-				9,430,532				6,274,087
Deferred gain rolled into cost basis of
acquired building		$	539,815				-				-
See accompanying notes to consolidated financial statements.

A-36

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Notes to Consolidated Financial Statements

(1)    Summary of Significant Accounting Policies

Organization

Peoples Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to operate as a bank holding company on July 22, 1999, and became effective August 31, 1999.  Bancorp is primarily regulated by the Board of Governors of the Federal Reserve System, and serves as the one-bank holding company for Peoples Bank.

Peoples Bank (the “Bank”) commenced business in 1912 upon receipt of its banking charter from the North Carolina State Banking Commission (the “SBC”). The Bank is primarily regulated by the SBC and the Federal Deposit Insurance Corporation and undergoes periodic examinations by these regulatory agencies. The Bank, whose main office is in Newton, North Carolina, provides a full range of commercial and consumer banking services primarily in Catawba, Alexander, Lincoln, Mecklenburg, Iredell and Union counties in North Carolina.

Peoples Investment Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1996 to provide investment and trust services through agreements with an outside party.

Real Estate Advisory Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1997 to provide real estate appraisal and property management services to individuals and commercial customers of the Bank.

Principles of Consolidation

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, the Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.

Basis of Presentation

The accounting principles followed by the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices in the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from these estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses and valuation of real estate acquired in connection with or in lieu of foreclosure on loans.

Cash and Cash Equivalents

Cash and due from banks and federal funds sold are considered cash and cash equivalents for cash flow reporting purposes. Generally, federal funds are sold for one-day periods.

Investment Securities

The Company classifies its securities in one of three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for sale in the near term. Held to maturity securities are those securities for which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held to maturity are classified as available for sale. At December 31, 2007 and 2006, the Company had classified all of its investment securities as available for sale.

Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders’ equity until realized.

A decline in the market value of any available for sale investment below cost that is deemed other than temporary is charged to earnings and establishes a new cost basis for the security.

Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to the yield.  Realized gains and losses for securities classified as available for sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.

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Other Investments

Other investments include equity securities with no readily determinable fair value.  These investments are carried at cost.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding.   The recognition of certain loan origination fee income and certain loan origination costs is deferred when such loans are originated and amortized over the life of the loan.

Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected.

Accrual of interest is discontinued on a loan when management believes, after considering economic conditions and collection efforts that the borrower’s financial condition is such that collection of interest is doubtful. Interest previously accrued but not collected is reversed against current period earnings and interest is recognized on a cash basis when such loans are placed on non-accrual status.

Allowance for Loan Losses

The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·   the Bank’s loan loss experience;

·   the amount of past due and non-performing loans;

·   specific known risks;

·   the status and amount of other past due and non-performing assets;

·   underlying estimated values of collateral securing loans;

·   current and anticipated economic conditions; and

·   other factors which management believes affect the allowance for potential credit losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment in accordance with SFAS No. 114, “Accounting By Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.  At December 31, 2007 and 2006, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $8.0 million and $7.6 million, respectively, with related allowance for loan losses of approximately $1.2 million for December 31, 2007 and 2006.

The general allowance reflects reserves established under the provisions of SFAS No. 5, “Accounting for Contingencies” for collective loan impairment.  These reserves are based upon historical net charge-offs using the last three years’ experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.

The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the  subjectivity involved in determining the overall allowance, including the unallocated portion, this

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unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.

Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2007 as compared to the year ended December 31, 2006. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.

Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.

Mortgage Banking Activities

Mortgage banking income represents net gains from the sale of mortgage loans and fees received from borrowers and loan investors related to the Company’s origination of single-family residential mortgage loans.

Mortgage servicing rights (“MSR's”) represent the unamortized cost of purchased and originated contractual rights to service mortgages for others in exchange for a servicing fee.  MSRs are amortized over the period of estimated net servicing income and are periodically adjusted for actual prepayments of the underlying mortgage loans. During the year ended December 31, 2006, the Company fully amortized the remaining balance of the Bank’s MSRs.  Management determined there was minimal fair value in the MSRs due to the small remaining balance in the loans serviced for others.  The Company amortized approximately $227,000 and $56,000 during 2006 and 2005, respectively.  No new servicing assets were recognized during 2007, 2006 and 2005.

Mortgage loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $12.1 million, $14.8 million and $18.1 million at December 31, 2007, 2006 and 2005, respectively.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily using the straight-line method over the estimated useful lives of the assets. When assets are retired or otherwise disposed, the cost and related accumulated depreciation are removed from the accounts, and any gain or loss is reflected in earnings for the period. The cost of maintenance and repairs that do not improve or extend the useful life of the respective asset is charged to earnings as incurred, whereas significant renewals and improvements are capitalized. The range of estimated useful lives for premises and equipment are generally as follows:

Buildings and improvements		10 - 50 years
Furniture and equipment		3 - 10 years

Foreclosed Assets

Foreclosed assets include all assets received in full or partial satisfaction of a loan and include real and personal property. Foreclosed assets are reported at the lower of carrying amount or net realizable value, and are included in other assets on the balance sheet.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carryforwards, is required to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.

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In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.

Derivative Financial Instruments and Hedging Activities

In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All derivative financial instruments are recorded at fair value in the financial statements.

On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.

If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge is terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.

The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.

Advertising Costs

The costs of advertising costs are expensed as incurred.

Accumulated Other Comprehensive Income

At December 31, 2007, accumulated other comprehensive income (loss) consisted of net unrealized gains on securities available for sale of $943,000 and net unrealized gains on derivatives of $765,000.  At December 31, 2006, accumulated other comprehensive income (loss) consisted of net unrealized losses on securities available for sale of $600,000 and net unrealized losses on derivatives of $171,000.

Stock-Based Compensation

The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  A total of 636,687 shares are currently reserved for possible issuance under this Plan.   All rights must be granted or awarded within ten years from the May 13, 1999 effective date of the plan.

Under the Plan, the Company has granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant.  The options granted in 1999 vested over a five-year period.  Options granted subsequent to 1999 vest over a three-year period.  All options expire after ten years.  A summary of the activity in the Plan is presented below:

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Stock Option Activity
For the years ended December 31, 2007, 2006 and 2005
		Shares				Weighted Average Option Price Per Share			Weighted Average Remaining Contractual Term (in years)		Aggregate  Intrinsic  Value
Outstanding, December 31, 2004			333,978			$	8.11
Granted during the period			-			$	-
Forfeited during the period			(1,970	)		$	7.77
Exercised during the period			(12,316	)		$	7.86
Outstanding, December 31, 2005			319,692			$	8.13
Granted during the period			-			$	-
Forfeited during the period			(164	)		$	7.38
Exercised during the period			(97,854	)		$	7.87
Outstanding, December 31, 2006			221,674			$	8.24
Granted during the period			-			$	-
Forfeited during the period			-			$	-
Exercised during the period			(28,949	)		$	8.26
Outstanding, December 31, 2007			192,725			$	8.24		4.05		$   1,303,460
Exercisable, December 31, 2007			192,725			$	8.24		4.05		$   1,303,460

Options outstanding at December 31, 2007 are exercisable at option prices ranging from $6.99 to $10.57, as presented in the table above.  Such options have a weighted average remaining contractual life of approximately four years.

The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (SFAS 123(R)), on January 1, 2006 using the “modified prospective” method. Under this method, awards that are granted, modified, or settled after December 31, 2005, are measured and accounted for in accordance with SFAS 123(R). Also under this method, expense is recognized for unvested awards that were granted prior to January 1, 2006, based upon the fair value determined at the grant date under SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123).  The Company recognized compensation expense for employee stock options of $10,000 and $6,000 for the years ended December 31, 2007 and 2006, respectively.  As of December 31, 2007, there was no unrecognized compensation cost related to nonvested employee stock options.

Prior to the adoption of SFAS 123(R), the Company accounted for stock compensation under Accounting Principles Board Opinion No. 25 and related interpretations.   Accordingly, the Company previously recognized no compensation cost for employee stock options.  The following table illustrates the effect on net earnings and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 as of December 31, 2005.

				2005
Net earnings	As reported		$	6,330,980
	Effect of grants			(143,747	)
	Effect of forfeitures			5,253
	Proforma		$	6,192,486
Basic earnings per share	As reported		$	1.11
	Proforma		$	1.09
Diluted earnings per share	As reported		$	1.09
	Proforma		$	1.07

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No options were granted during the years ended December 31, 2007 and 2006.  The total intrinsic value (amount by which the fair market value of the underlying stock exceeds the exercise price of an option on exercise date) of options exercised during the years ended December 31, 2007 and 2006 was $264,000 and $923,000, respectively.  There were 2,420 options vested during the years ended December 31, 2007 and 2006.  Cash received from option exercises for the years ended December 31, 2007 and 2006 was $239,000 and $771,000, respectively.  The tax benefit for the tax deductions from option exercises totaled $92,000 and $243,000, respectively for the years ended December 31, 2007 and 2006.

The Company granted 3,000 shares of restricted stock during the three months ended September 30, 2007.  These restricted stock grants cliff vest three years after issuance.  The fair value of the restricted stock granted is $17.40 per share. As of September 30, 2007, there was $48,000 of total unrecognized compensation cost related to restricted stock grants, which is expected to be recognized over a period of 3 years.

Net Earnings Per Share

Net earnings per share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per share. The average market price during the year is used to compute equivalent shares.

The reconciliations of the amounts used in the computation of both “basic earnings per share” and “diluted earnings per share” for the years ended December 31, 2007, 2006 and 2005 are as follows:

							Common				Per Share
For the year ended December 31, 2007:			Net Earnings				Shares				Amount
Basic earnings per share		$	9,591,971				5,700,860			$	1.68
Effect of dilutive securities:
Stock options			-				109,455
Diluted earnings per share		$	9,591,971				5,810,315			$	1.65
For the year ended December 31, 2006:							Common				Per Share
			Net Earnings				Shares				Amount
Basic earnings per share		$	9,170,817				5,701,829			$	1.61
Effect of dilutive securities:
Stock options			-				100,495
Diluted earnings per share		$	9,170,817				5,802,324			$	1.58
For the year ended December 31, 2005:							Common				Per Share
			Net Earnings				Shares				Amount
Basic earnings per share		$	6,330,980				5,692,290			$	1.11
Effect of dilutive securities:
Stock options			-				100,084
Diluted earnings per share		$	6,330,980				5,792,374			$	1.09

On April 19, 2007, the Board of Directors of the Company authorized a 3-for-2 stock split that was paid in conjunction with the Company’s regular cash dividend for the second quarter of 2007.  As a result of the stock split, each shareholder received three new shares of stock for every two shares of stock they held as of the record date.  Shareholders received a cash payment in lieu of any fractional shares resulting from the stock split.  The cash dividend was paid based on the number of shares held by shareholders as adjusted by the stock split.  All previously reported per share amounts have been restated to reflect this stock split.

Recent Accounting Pronouncements

In June 2006, FASB issued Financial Interpretation No. 48 ("FIN 48") "Accounting for Uncertainty in Income Taxes - an interpretation of SFAS No. 109".   FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements and prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return.   This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  This interpretation was effective for the Company beginning in January of 2007.   The Company assessed the impact of FIN 48 and determined that there are no significant positions taken in the preparation of its tax return, and therefore FIN 48 did not have a material impact on its financial position or its results of operations.

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In September 2006, the FASB ratified the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4, "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements."   This issue will require companies to recognize an obligation for either the present value of the entire promised death benefit or the annual "cost of insurance" required to keep the policy in force during the post-retirement years.  EITF 06-4 is effective for the Company as of January 1, 2008.  This standard is not expected to have a material effect on the Company's financial position, results of operations or disclosures. 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157).  SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.  SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements.  SFAS 157 is effective for the Company as of January 1, 2008.  This standard is not expected to have a material effect on the Company's financial position or results of operations

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158) – an amendment of FASB Statements No. 87, 88, 106 and 132(R).  SFAS 158 requires employers to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income.  SFAS 158 requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions and includes expanded disclosures.  SFAS 158 was effective for the Company as of January 1, 2007.  This standard did not have a material effect on the Company's financial position, results of operations or disclosures.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159), which permits entities to choose to measure financial instruments and certain other instruments at fair value.  SFAS 159 is effective for the Company as of January 1, 2008.    The Company does not expect to choose this option for any asset or liability and therefore does not expect SFAS 159 to have a material effect on the Company's financial position, results of operations or disclosures.

Reclassification

Certain amounts in the 2005 consolidated financial statements have been reclassified to conform to the 2007 and 2006 presentation.

(2)     Investment Securities

Investment securities available for sale at December 31, 2007 and 2006 are as follows:

			December 31, 2007
							Gross				Gross
			Amortized				Unrealized				Unrealized				Estimated Fair
			Cost				Gains				Losses				Value
Mortgage-backed securities		$	16,469,053				6,423				204,509				16,270,967
U.S. government agencies			75,155,693				1,839,143				3,035				76,991,801
State and political subdivisions			25,856,311				250,483				201,406				25,905,388
Trust preferred securities			250,000				-				-				250,000
Equity securities			1,692,799				246,000				388,597				1,550,202
Total		$	119,423,856				2,342,049				797,547				120,968,358

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		December 31, 2006
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Estimated Fair Value
Mortgage-backed securities	$		19,666,345				-				446,751				19,219,594
U.S. government agencies			72,838,407				171,828				265,821				72,744,414
State and political subdivisions			24,493,444				242,204				369,178				24,366,470
Trust preferred securities			750,000				-				-				750,000
Equity securities			814,995				-				314,473				500,522
Total	$		118,563,191				414,032				1,396,223				117,581,000

The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2007 and 2006 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.

			December 31, 2007
			Less than 12 Months				12 Months or More				Total
					Unrealized				Unrealized				Unrealized
			Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Mortgage-backed securities		$	24,591		104		14,320,043		204,405		14,344,634		204,509
U.S. government agencies			-		-		689,775		3,035		689,775		3,035
State and political subdivisions			2,059,746		33,781		11,188,720		167,625		13,248,466		201,406
Equity securities			425,620		88,134		278,581		300,463		704,201		388,597
Total		$	2,509,957		122,019		26,477,119		675,528		28,987,076		797,547

			December 31, 2006
			Less than 12 Months				12 Months or More				Total
					Unrealized				Unrealized				Unrealized
			Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
Mortgage-backed securities		$	-		-		19,202,188		446,751		19,202,188		446,751
U.S. government agencies			23,069,770		13,361		21,510,425		252,460		44,580,195		265,821
State and political subdivisions			1,445,462		35,988		11,589,682		333,190		13,035,144		369,178
Equity securities			-		-		500,522		314,473		500,522		314,473
Total		$	24,515,232		49,349		52,802,817		1,346,874		77,318,049		1,396,223

At December 31, 2007, unrealized losses in the investment securities portfolio related to debt securities totaled $409,000.  The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary.  From the December 31, 2007 tables above, 32 out of 72 securities issued by state and political subdivisions contained unrealized losses and 19 out of 59 securities issued by U.S. government agencies and government sponsored corporations, including mortgage-backed securities, contained unrealized losses.  These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.

The Company periodically evaluates its investments for any impairment which would be deemed other than temporary.   As part of its evaluation in 2007, the Company determined that the fair value of two investments was less than the original cost of the investments and that the decline in fair value was not temporary in nature.  As a result, the Company wrote down its original investment by $430,000.  The remaining value of the investments at December 31, 2007 is $348,000.

The amortized cost and estimated fair value of investment securities available for sale at December 31, 2007, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

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			Amortized				Estimated Fair
			Cost				Value
Due within one year		$	7,319,434				7,331,682
Due from one to five years			56,422,798				57,569,880
Due from five to ten years			29,280,174				29,899,813
Due after ten years			8,239,598				8,345,814
Mortgage-backed securities			16,469,053				16,270,967
Equity securities			1,692,799				1,550,202
Total		$	119,423,856				120,968,358

Proceeds from sales of securities available for sale during 2007, 2006 and 2005 were $8.4 million, $19.9 million and $27.8 million, respectively. Gross losses of $132,000, $592,000 and $730,000 for 2007, 2006 and 2005, respectively, were realized on those sales.

Securities with a fair value of approximately $50.4 million and $25.0 million at December 31, 2007 and 2006, respectively, were pledged to secure public deposits and for other purposes as required by law.

(3)     Loans

Major classifications of loans at December 31, 2007 and 2006 are summarized as follows:

			2007				2006
Commercial		$	82,190,391				85,064,322
Real estate - mortgage			417,708,750				364,595,188
Real estate - construction			209,643,836				187,959,880
Consumer			12,733,971				13,761,739
Total loans			722,276,948				651,381,129
Less allowance for loan losses			9,103,058				8,303,432
Total net loans		$	713,173,890				643,077,697

The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg and Union Counties.  Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.

At December 31, 2007 and 2006, the recorded investment in loans that were considered to be impaired was approximately $8.0 million and $7.6 million, respectively. In addition, the Company had approximately $0 and $78,000 in loans past due more than ninety days and still accruing interest at December 31, 2007 and 2006, respectively.  The related allowance for loan losses on impaired loans was approximately $1.2 million at December 31, 2007 and 2006. The average recorded investment in impaired loans for the twelve months ended December 31, 2007, 2006 and 2005 was approximately $7.3 million, $4.7 million and $6.2 million, respectively. For the years ended December 31, 2007, 2006 and 2005, the Company recognized approximately $29,000, $144,000 and $77,000, respectively, of interest income on impaired loans.

Changes in the allowance for loan losses were as follows:

			2007				2006				2005
Balance at beginning of year		$	8,303,432				7,424,782				8,048,627
Amounts charged off			(1,626,458	)			(1,958,551	)			(4,199,650	)
Recoveries on amounts previously charged off			388,084				323,919				465,805
Provision for loan losses			2,038,000				2,513,282				3,110,000
Balance at end of year		$	9,103,058				8,303,432				7,424,782

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(4)     Premises and Equipment

Major classifications of premises and equipment are summarized as follows:

			2007				2006
Land		$	3,572,241				2,349,041
Buildings and improvements			14,700,078				10,618,896
Furniture and equipment			15,496,630				13,992,524
Total premises and equipment			33,768,949				26,960,461
Less accumulated depreciation			15,534,556				14,144,076
Total net premises and equipment		$	18,234,393				12,816,385

Depreciation expense was approximately $1.7 million for the year ended December 31, 2007.  The Company recognized approximately $1.5 million in depreciation expense for the years ended December 31, 2006 and 2005.

During 2003, the Company sold a branch location with net book value of approximately $2.4 million and was leasing the facility from the buyer.  As a result of the sale, the Company deferred a gain of approximately $633,000 and was recognizing the gain over the lease term.  For the period ended December 31, 2007 the Company recognized approximately $10,000 of the deferred gain and for the periods ended December 31, 2006 and 2005, respectively, approximately $21,000 and $22,000 of the deferred gain was recognized.  In 2007, the Company repurchased the branch location for $3.0 million, which was $588,000 greater than the original cost of the building.  The remaining deferred gain was netted against the purchase price resulting in a net cost of $2.5 million. This cost is being depreciated over 39 years.

(5)     Time Deposits

At December 31, 2007, the scheduled maturities of time deposits are as follows:

2008		$	363,236,019
2009			17,088,127
2010			3,153,109
2011			200,648
2012 and thereafter			929,815
Total		$	384,607,718

At December 31, 2007 and 2006, the Company has approximately $53.9 million and $60.0 million, respectively, in time deposits purchased through third party brokers.  The weighted average rate of brokered deposits as of December 31, 2007 and 2006 was 5.06% and 5.11%, respectively.

(6)     Federal Home Loan Bank Advances

The Bank has advances from the Federal Home Loan Bank of Atlanta (“FHLB”) with monthly or quarterly interest payments at December 31, 2007. The FHLB advances are collateralized by a blanket assignment on all residential first mortgage loans, commercial real estate loans, home equity lines of credit and loans secured by multi-family real estate that the Bank owns.  At December 31, 2007, the carrying value of loans pledged as collateral totaled approximately $239.0 million.

Advances from the FHLB outstanding at December 31, 2007 consist of the following:

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Maturity Date		Call Date		Rate			Rate Type		Amount
February 4, 2008		N/A			4.400%		Daily Rate		$	10,500,000
March 30, 2010		September 30, 2000 and every
		three months thereafter			5.880%		Convertible			5,000,000
May 24, 2010		May 24, 2001 and every three
		months thereafter			6.490%		Convertible			2,000,000
June 24, 2015		June 24, 2010			3.710%		Convertible			5,000,000
March 25, 2019		March 25, 2009			4.360%		Convertible			5,000,000
March 31, 2016		March 31, 2009 and every three
		months thereafter			4.620%		Convertible			5,000,000
October 5, 2016		October 5, 2009			4.450%		Convertible			5,000,000
December 12, 2011		December 12, 2007 and every			4.210%		Convertible			5,000,000
		three months thereafter
January 30, 2017		October 30, 2008 and every			4.500%		Convertible			5,000,000
		three months thereafter
June 8, 2017		December 8, 2008 and every			4.713%		Convertible			15,000,000
		three months thereafter
June 9, 2014		February 11, 2008 and every			4.685%		Convertible			15,000,000
		month thereafter
July 11, 2017		January 11, 2008 and every			4.440%		Convertible			5,000,000
		three months thereafter
July 24, 2017		April 24, 2008 and every			4.420%		Convertible			5,000,000
		month thereafter
									$	87,500,000

The FHLB has the option to convert $72.0 million of the total advances to a floating rate and, if converted, the Bank may repay advances without payment of a prepayment fee.  The Company also has an additional $5.0 million in variable rate convertible advances, which may be repaid without a prepayment fee if converted by the FHLB.

The Bank is required to purchase and hold certain amounts of FHLB stock in order to obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no quoted market value. The stock is redeemable at $100 per share subject to certain limitations set by the FHLB. At December 31, 2007 and 2006, the Bank owned FHLB stock amounting to $5.4 million and $5.5 million, respectively.

(7)     Junior Subordinated Debentures

In June 2006 the Company formed a second wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments.  The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

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These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

(8)     Income Taxes

The provision for income taxes in summarized as follows:

			2007				2006				2005
Current		$	5,819,347				5,785,926				3,048,094
Deferred			(479,806	)			(615,626	)			332,806
Total		$	5,339,541				5,170,300				3,380,900

The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to earnings before income taxes are as follows:

			2007				2006				2005
Pre-tax income at statutory rates (34%)		$	5,076,714				4,875,980				3,302,039
Differences:
Tax exempt interest income			(307,169	)			(280,826	)			(263,555	)
Nondeductible interest and other expense			55,871				45,872				30,511
Cash surrender value of life insurance			(82,951	)			(75,021	)			(73,973	)
State taxes, net of federal benefits			559,905				576,444				363,264
Other, net			37,170				27,851				22,614
Total		$	5,339,541				5,170,300				3,380,900

The following summarized the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities.  The net deferred tax asset is included as a component of other assets at December 31, 2007 and 2006.

               

			2007				2006
Deferred tax assets:
Allowance for loan losses		$	3,531,076				3,201,305
Amortizable intangible assets			76,398				108,472
Accrued retirement expense			819,246				664,581
Income from non-accrual loans			50,219				72,475
Deferred gain on sale of premises			-				212,820
Unrealized loss on cash flow hedges			20,525				328,933
Unrealized loss on available for sale securities			-				382,564
Premises and equipment			9,757				-
Total gross deferred tax assets			4,507,221				4,971,150
Deferred tax liabilities:
Deferred loan fees			1,346,322				1,310,178
Premises and equipment			-				291,107
Deferred income from servicing rights			-				-
Unrealized gain on available for sale securities			601,583				-
Other			12,482				10,283
Total gross deferred tax liabilities			1,960,387				1,611,568
Net deferred tax asset		$	2,546,834				3,359,582

(9)           Related Party Transactions

The Company conducts transactions with its directors and executive officers, including companies in which they have beneficial interests, in the normal course of business. It is the policy of the Company that loan transactions with directors and officers are made on substantially the same terms as those prevailing at the time made for comparable loans to other persons. The following is a summary of activity for related party loans for 2007:

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Beginning balance		$	7,274,778
New loans			1,153,336
Repayments			2,812,215
Ending balance		$	5,615,899

At December 31, 2007 and 2006, the Company had deposit relationships with related parties of approximately $15.7 million and $9.1 million, respectively.

(10)     Commitments and Contingencies

The Company leases various office spaces for banking and operational facilities and equipment under operating lease arrangements. Future minimum lease payments required for all operating leases having a remaining term in excess of one year at December 31, 2007 are as follows:

Year
2008		$	897,192
2009			753,827
2010			626,965
2011			563,901
2012			298,771
Thereafter			2,149,222
Total minimum obligation		$	5,289,878

Total rent expense was approximately $1.1 million, $959,000 and $956,000 for 2007, 2006 and 2005, respectively.

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees.  Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.  The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

In most cases, the Company requires collateral or other security to support financial instruments with credit risk.

			Contractual Amount
			2007				2006
Financial instruments whose contract amount represent credit risk:
Commitments to extend credit		$	190,653,583				157,358,229
Standby letters of credit and financial guarantees written		$	3,894,259				4,573,544

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates and because they may expire without being drawn upon, the total commitment amount of $194.5 million does not necessarily represent future cash requirements. 

Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to businesses in the Company’s delineated market area. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds real estate, equipment, automobiles and customer deposits as collateral supporting those commitments for which collateral is deemed necessary.

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The Company has an overall interest rate-risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company attempts to minimize the credit risk in derivative instruments by entering into transactions with counterparties that are reviewed periodically by the Company and are believed to be of high quality.

In the normal course of business, the Company is a party (both as plaintiff and defendant) to a number of lawsuits. In the opinion of management and counsel, none of these cases should have a material adverse effect on the financial position of the Bank or the Company.

The Company has employment agreements with certain key employees. The agreements, among other things, include salary, bonus, incentive stock option, and change in control provisions.

The Company has $35.0 million available for the purchase of overnight federal funds from three correspondent financial institutions.

(11)     Derivative Financial Instruments and Hedging Transactions

The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.

 As of December 31, 2007, the Company had cash flow hedges with a notional amount of $185.0 million.  These derivative instruments consist of five interest rate floor contracts that are used to hedge future cash flows from payments on the first $185.0 million of certain variable rate loans against the downward effects of their repricing in the event of a decreasing rate environment for periods ending in July 2008, November 2008, January 2009, June 2009 and December 2009.  If the prime rate falls below 6.25% during the term of the contract on the first floor, the Company will receive payments based on the $35.0 million notional amount times the difference between 6.25% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 6.25% or higher.  The Company paid a premium of $161,000 on this contact.  On the second floor if the prime rate falls below 7.00% during the term of the contract, the Company will receive payments based on the $35.0 million notional amount times the difference between 7.00% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 7.00% or higher.  The Company paid a premium of $203,000 on this contract. On the third floor if the prime rate falls below 7.50% during the term of the contract, the Company will receive payments based on the $45.0 million notional amount times the difference between 7.50% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 7.50% or higher.  The Company paid a premium of $562,500 on this contract.  On the fourth floor if the prime rate falls below 8.00% during the term of the contract, the Company will receive payments based on the $35.0 million notional amount times the difference between 8.00% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 8.00% or higher.  The Company paid a premium of $399,000 on this contract.  On the fifth floor if the prime rate falls below 7.25% during the term of the contract, the Company will receive payments based on the $35.0 million notional amount times the difference between 7.25% and the weighted average prime rate for the quarter.  No payments will be received by the Company if the weighted average prime rate is 7.25% or higher. The Company paid a premium of $634,000 on this contract.

The Company recognized $47,000 in interest income from payments on interest rate floor contracts in 2007.

(12)     Employee and Director Benefit Programs

The Company has a profit sharing and 401(k) plan for the benefit of substantially all employees subject to certain minimum age and service requirements. Under this plan, the Company matches employee contributions to a maximum of five percent of annual compensation. The Company’s contribution pursuant to this formula was approximately $424,000, $405,000 and $360,000 for the years of 2007, 2006 and 2005, respectively. Investments of the plan are determined by the compensation committee consisting of selected outside directors and senior executive officers. No investments in Company stock have been made by the plan. The vesting schedule for the

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plan begins at 20 percent after two years of employment and graduates 20 percent each year until reaching 100 percent after six years of employment.

In December 2001, the Company initiated a postretirement benefit plan to provide retirement benefits to key officers and its Board of Directors and to provide death benefits for their designated beneficiaries.  Under the plan, the Company purchased life insurance contracts on the lives of the key officers and each director.  The increase in cash surrender value of the contracts constitutes the Company’s contribution to the plan each year.  Plan participants are to be paid annual benefits for a specified number of years commencing upon retirement. Expenses incurred for benefits relating to this plan were approximately $258,000, $240,000 and $245,000 during 2007, 2006 and 2005, respectively.

The Company is currently paying medical benefits for certain retired employees. Postretirement benefits expense, including amortization of the transition obligation, as applicable, was approximately $23,000 for the years ended December 31, 2007, 2006 and 2005. The following table sets forth the accumulated postretirement benefit obligation as of December 31, 2007 and 2006, which represents the liability for accrued postretirement benefit costs:

			2007				2006
Accumulated postretirement benefit obligation		$	170,302				196,002
Unrecognized gain (loss)			(21,576	)			(38,327	)
Net liability recognized		$	148,726				157,675

In September 2006, the FASB released SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” which requires employers to recognize the overfunded or underfunded status of defined benefit postretirement plans.  The effective date for public companies is for years ending after December 15, 2006.  Management has compared the accrued postretirement benefit expense and the charge to other comprehensive income, as calculated in accordance with SFAS 106 and 132 to the requirement under SFAS 158 and determined that the difference is immaterial.

Members of the Board of Directors are eligible to participate in the Company’s Omnibus Stock Ownership and Long Term Incentive Plan (the “Stock Benefits Plan”).  Each director has been awarded 9,737 book value shares (adjusted to reflect a 10% stock dividend on April 24, 2000, a 10% stock dividend on March 16, 2005, a 10% stock divided on June 16, 2006 and a 3-for-2 stock split on June 15, 2007) under the Stock Benefits Plan.  Five directors were awarded book value shares on September 28, 1999.  The book value of the common stock on September 28, 1999 was $6.31 (as adjusted).  These book value shares are now fully vested.  One director was awarded 9,737 book value shares upon his election to the Board of Directors on May 3, 2001.  The book value of the common stock on May 3, 2001 was $7.69 (as adjusted).  These book value shares are now fully vested.  Four directors were awarded 9,737 book value shares on May 6, 2004.  The book value of the common stock on May 6, 2004 was $8.64 (as adjusted).  Their shares vest at a rate of 20% annually, with the first 20% vesting on May 6, 2005, and the final 20% vesting on May 6, 2009.  The Company recorded expenses of approximately $159,000, $128,000 and $102,000 associated with the benefits of this plan in the years ended December 31, 2007, 2006 and 2005, respectively.

A summary of book value shares activity under the Stock Benefits Plan for the years ended December 31, 2007, 2006 and 2005 is presented below.

		2007						2006							2005
		Shares			Weighted Average Price of Book Value Shares			Shares			Weighted Average Price of Book Value Shares				Shares			Weighted Average Price of Book Value Shares
Outstanding, beginning of period			97,377		$	7.38			97,377		$	7.38			116,850			$	7.20
Exercised during the period			-		$	-			-		$	-			(19,473	)		$	6.31
Outstanding, end of period			97,377		$	7.38			97,377		$	7.38			97,377			$	7.38
Number of shares exercisable			81,791		$	7.89			73,998		$	6.98			66,208			$	6.79

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(13)     Regulatory Matters

The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of capital in relation to both on- and off-balance sheet items at various risk weights. Total capital consists of two tiers of capital. Tier 1 Capital includes common shareholders’ equity and trust preferred securities less adjustments for intangible assets. Tier 2 Capital consists of the allowance for loan losses up to 1.25% of risk-weighted assets and other adjustments. Management believes, as of December 31, 2007, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2007, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.

The Company’s and the Bank’s actual capital amounts and ratios are presented below:

		Actual								For Capital Adequacy Purposes								To Be Well Capitalized Under Prompt Corrective Action Provisions
		Amount				Ratio				Amount				Ratio				Amount				Ratio
		(dollars in thousands)
As of December 31, 2007:
Total Capital (to Risk-Weighted Assets)
Consolidated		$	97,410				12.16	%			64,071				8.00	%			N/A				N/A
Bank		$	87,393				10.93	%			63,940				8.00	%			79,926				10.00	%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated		$	88,307				11.03	%			32,035				4.00	%			N/A				N/A
Bank		$	78,290				9.80	%			31,970				4.00	%			47,955				6.00	%
Tier 1 Capital (to Average Assets)
Consolidated		$	88,307				10.43	%			33,873				4.00	%			N/A				N/A
Bank		$	78,290				9.26	%			33,827				4.00	%			42,284				5.00	%
As of December 31, 2006:
Total Capital (to Risk-Weighted Assets)
Consolidated		$	91,718				12.86	%			57,056				8.00	%			N/A				N/A
Bank		$	80,857				11.37	%			56,875				8.00	%			71,094				10.00	%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated		$	83,415				11.70	%			28,528				4.00	%			N/A				N/A
Bank		$	72,554				10.21	%			28,438				4.00	%			42,656				6.00	%
Tier 1 Capital (to Average Assets)
Consolidated		$	83,415				10.80	%			30,903				4.00	%			N/A				N/A
Bank		$	72,554				9.41	%			30,857				4.00	%			38,571				5.00	%

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(14)     Shareholders’ Equity

In November 2006, the Company’s Board of Directors authorized the repurchase of up to $2.0 million in common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of November 2007.  During 2007 the Company repurchased 100,000 shares, or $1,938,000 of its common stock under this plan.

In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008.  The Company has repurchased 50,497 shares, or $873,000, of its common stock under this plan as of December 31, 2007.

The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.

The Board of Directors of the Bank may declare a dividend of all of its retained earnings as it may deem appropriate, subject to the requirements of the General Statutes of North Carolina, without prior approval from the requisite regulatory authorities. As of December 31, 2007, this amount was approximately $19.7 million.

(15)     Other Operating Expense

Other operating expense for the years ended December 31 included the following items that exceeded one percent of total revenues:

			2007				2006				2005
Advertising		$	988,116				772,917				656,184

(16)     Fair Value of Financial Instruments

The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.

Cash and Cash Equivalents

For cash, due from banks, interest bearing deposits and federal funds sold, the carrying amount is a reasonable estimate of fair value.

Investment Securities Available for Sale

Fair values for investment securities are based on quoted market prices.

Other Investments

For other investments, the carrying value is a reasonable estimate of fair value.

Loans

The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.

Cash Surrender Value of Life Insurance

For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.

Derivative Instruments

For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.

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Deposits and Demand Notes Payable

The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

FHLB Advances

The fair value of FHLB advances is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.

Junior Subordinated Debentures

Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.

Commitments to Extend Credit and Standby Letters of Credit

Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2007 and 2006 are as follows:

               

		2007								2006
		Carrying				Estimated				Carrying				Estimated
		Amount				Fair Value				Amount				Fair Value
		(dollars in thousands)
Assets:
Cash and cash equivalents	$		29,800				29,800				21,500				21,500
Investment securities available for sale	$		120,968				120,968				117,581				117,581
Other investments	$		6,434				6,434				7,295				7,295
Loans, net	$		713,174				713,689				643,078				641,414
Cash surrender value of life insurance	$		6,776				6,776				6,532				6,532
Derivative instruments	$		1,907				1,907				481				481
Liabilities:
Deposits and demand notes payable	$		695,239				695,659				635,420				635,371
FHLB advances	$		87,500				90,223				89,300				88,819
Junior subordinated debentures	$		20,619				20,619				20,619				20,619

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(17)           Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements

Balance Sheets
December 31, 2007 and 2006
Assets		2007				2006
Cash		$	725,416				1,646,880
Interest-bearing time deposit			8,000,000				8,000,000
Investment in subsidiaries			80,703,540				72,593,671
Investment securities available for sale			1,374,581				750,521
Other investments			-				600,000
Other assets			251,724				293,049
Total assets		$	91,055,261				83,884,121
Liabilities and Shareholders' Equity
Accrued expenses		$	334,679				429,748
Junior subordinated debentures			20,619,000				20,619,000
Shareholders' equity			70,101,582				62,835,373
Total liabilities and shareholders' equity		$	91,055,261				83,884,121

Statements of Earnings
For the Years Ended December 31, 2007, 2006 and 2005
Revenues:		2007				2006				2005
Dividends from subsidiaries		$	4,811,203				3,855,556				2,346,897
Interest and dividend income			463,866				672,922				111,777
Loss on sale of securities			(235,950	)			-				-
Total revenues			5,039,119				4,528,478				2,458,674
Expenses:
Interest			1,475,701				1,962,692				938,145
Other operating expenses			266,146				786,014				289,691
Total expenses			1,741,847				2,748,706				1,227,836
Earnings before income tax benefit and equity in
undistributed earnings of subsidiaries			3,297,272				1,779,772				1,230,838
Income tax benefit			514,800				705,800				379,500
Earnings before undistributed earnings in subsidiaries			3,812,072				2,485,572				1,610,338
Equity in undistributed earnings in subsidiaries			5,779,899				6,685,245				4,720,642
Net earnings		$	9,591,971				9,170,817				6,330,980

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Statements of Cash Flows
For the Years Ended December 31, 2007, 2006 and 2005
		2007				2006				2005
Cash flows from operating activities:
Net earnings		$	9,591,971				9,170,817				6,330,980
Adjustments to reconcile net earnings to net
cash provided by operating activities:
Amortization			-				461,298				17,742
Book value shares accrual			158,678				128,444				21,818
Equity in undistributed earnings of subsidiaries			(5,779,899	)			(6,685,245	)			(4,720,642	)
Deferred income tax benefit			(61,551	)			(49,520	)			(8,412	)
Loss on sale of investment securities			235,950				-				-
Change in:
Accrued income			1,603				(1,421	)			17,930
Accrued expense			(253,748	)			25,975				(21,063	)
Net cash provided by operating activities			3,893,004				3,050,348				1,638,353
Cash flows from investing activities:
Net change in interest-bearing time deposit			-				(6,000,000	)			-
Purchases of other investments			-				(600,000	)			-
Purchase of equity in PEBK Capital Trust II			-				(619,000	)			-
Proceeds from liquidation of PEBK Capital Trust I			-				433,000				-
Net cash used by investing activities			-				(6,786,000	)			-
Cash flows from financing activities:
Proceeds from issuance of trust preferred securities			-				20,619,000				-
Repayments of trust preferred securities			-				(14,433,000	)			-
Cash dividends paid			(2,331,203	)			(1,905,556	)			(1,414,239	)
Cash paid in lieu of fractional shares			(3,355	)			(6,426	)			(4,700	)
Common stock repurchased			(2,810,907	)			(425,000	)			(314,750	)
Proceeds from exercise of stock options			330,997				1,014,425				96,773
Net cash provided (used) by financing activities			(4,814,468	)			4,863,443				(1,636,916	)
Net change in cash			(921,464	)			1,127,791				1,437
Cash at beginning of year			1,646,880				519,089				517,652
Cash at end of year		$	725,416				1,646,880				519,089

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DIRECTORS AND OFFICERS OF THE COMPANY

DIRECTORS

Robert C. Abernethy – Chairman

Chairman of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples Bank;

President, Secretary and Treasurer, Carolina Glove Company, Inc. (glove manufacturer)

James S. Abernethy

President and Assistant Secretary, Midstate Contractors, Inc. (paving company)

Douglas S. Howard

Vice President, Howard Ventures, Inc. (private equity firm)

John W. Lineberger, Jr.

President, Lincoln Bonded Warehouse Company (commercial warehousing and distribution facility)

Gary E. Matthews

President and Director, Matthews Construction Company, Inc. (general contractor)

Billy L. Price, Jr. MD

Practicing Internist and Partner, Catawba Valley Internal Medicine, P.A.

Larry E. Robinson

President and Chief Executive Officer, The Blue Ridge Distributing Co., Inc. (beer and wine distributor)

William Gregory (Greg) Terry

Executive Vice President, Drum & Willis-Reynolds Funeral Homes and Crematory

Dan Ray Timmerman, Sr.

President, Timmerman Manufacturing, Inc. (wrought iron furniture manufacturer)

Benjamin I. Zachary

President, Treasurer, General Manager and Member of the Board of Directors,

Alexander Railroad Company

OFFICERS

Tony W. Wolfe

President and Chief Executive Officer

Joseph F. Beaman, Jr.

Executive Vice President and Corporate Secretary

Lance A. Sellers

Executive Vice President and Assistant Corporate Secretary

William D. Cable, Sr.

Executive Vice President and Assistant Corporate Treasurer

A. Joseph Lampron

Executive Vice President, Chief Financial Officer and Corporate Treasurer

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