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

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

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

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

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

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

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

In addition, the Bank has agreed that it will:

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

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

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

In addition, the Company has agreed that it will:

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

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

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

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

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

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

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

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

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

The Company is committed to expeditiously addressing and resolving the issues raised in the Written Agreement. As such, the Board of Directors has established an Enforcement Action Committee that meets regularly to monitor the Bank's progress on compliance with the Written Agreement. The Bank has made progress on multiple provisions included in the Written Agreement and continues to aggressively work to implement any necessary changes to policies and procedures. Several control changes have been implemented to address the financial reporting material weaknesses, identified as of December 31, 2010, of identification and valuation of impaired loans, the support and validation of the allowance for loan losses, and the valuation of foreclosed assets. Additionally, the Bank has implemented additional controls around obtaining updated collateral valuations as required by regulation

and has established new policies to further reduce Commercial Real Estate concentrations, ensure current financial information is evaluated, and control interest only loans. Other areas also being addressed are the adequacy of credit resources, portfolio risk management and reporting,and consistency and compliance when dealing with loan workouts. A material failure to comply with the terms of the Written Agreement could subject the Company to additional regulatory actions and further restrictions on its business. These regulatory actions and resulting restrictions on the Company's business may have a material adverse effect on its future results of operations and financial condition.

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

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

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

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

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

Comparison of Financial Condition at March 31, 2012 and December 31, 2011

The Company's total assets increased from $916.6 million at December 31, 2011 to $934.5 million at March 31, 2012, an increase of $17.9 million, or 1.95%. The Company's liquid assets, consisting of cash and cash equivalents and investment securities, increased $39.1 million to $317.3 million during the three months ended March 31, 2012 compared to liquid assets of $278.2 million as of December 31, 2011 primarily from increases in cash and cash equivalents of $15.4 million, and investment securities available for sale and held to maturity of $23.7 million. Gross loans decreased by $22.6 million or 3.75% from $602.2 million at December 31, 2011 to $579.7 million at March 31, 2012. The Company's loan portfolio declined due to payoffs, paydowns and charge-offs. Deposits increased $14.3 million or 1.92% from $745.9 million at December 31, 2011 to $760.2 million at March 31, 2012, due to an increase in non-interest bearing, non-maturity deposits of $13.0 million and an increase in interest bearing demand deposits of $6.5 million, offset by a $8.3 million decrease in wholesale deposits.

Total shareholders' equity increased approximately $809,000 from $29.7 million at December 31, 2011 to $30.5 million at March 31, 2012. The increase resulted primarily from net income of $552,000 and an increase in other comprehensive income of $195,000.

Results of Operations for the Three Months Ended March 31, 2012 and 2011

Net Income. Net income for the three months ended March 31, 2012 was $552,000, or $0.07 per basic and diluted share, as compared to a net loss of $1.1 million, or $0.15 per basic and diluted share, for the three months ended March 31, 2011, a positive change of $1.7 million or $0.22 per basic and diluted share. The primary reasons for net income in the first quarter of 2012 are a decrease in loan losses resulting in quarterly loan loss provision of $(247,000) due to improved risk grade migration trends, and continued contraction of the loan portfolio. Reductions in other expenses due to cost cutting measures were offset by increased collection expense of $472,000.

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

Net interest income for the three months ended March 31, 2012 was $5.9 million, a decrease of $1.1 million compared to the three months ended March 31, 2011. Net interest income and margins decreased during the period, primarily due to the $22.6 million decrease in the loan portfolio, increases in nonaccrual loans, and lower yields on investments from March 31, 2011, resulting in a decrease in the Company's net interest margin by 37 basis points from 3.09% during the three months ended March 31, 2011 to 2.72% during the three months ended March 31, 2012. The average cost on interest-bearing liabilities for the quarter ended

March 31, 2012 declined 6 basis points from 1.82% at March 31, 2011 to 1.76% at March 31, 2012. Average interest-earning assets decreased $37.8 million primarily due to increased liquid assets. Average interest-bearing liabilities decreased $77.1 million due to reductions of wholesale deposits.

Provision for Loan Losses. The provision for loan losses is charged to bring the allowance for loan losses to the level deemed appropriate by management after adjusting for recoveries of amounts previously charged off. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of a loan balance is confirmed. The allowance for loan losses is maintained at a level deemed adequate to absorb probable losses inherent in the loan portfolio and results from management's consideration of such factors as the financial condition of borrowers, past and expected loss experience, current economic conditions, and other factors management feels deserve recognition in establishing an appropriate reserve. Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions or the status of the loans included in the loan portfolio. In addition, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to make adjustments based upon their judgments about information available to them at the time of their examination.

Our non-performing assets, which consist of loans past due 90 days or more, foreclosed assets, and loans in nonaccrual status, decreased to $69.6 million at March 31, 2012 from $72.4 million at December 31, 2011. This decrease was primarily due to the improvements in the housing market and real estate construction, and our improved processes for addressing these assets. The decrease in the provision for loan losses for the three months ended March 31, 2012 was $(247,000) as compared to an increase of $2.6 million for the same period in 2011. Net charge-offs as a percentage of average loans decreased 13 basis points, from 0.38% for the three month period ended March 31, 2011 to 0.25% for the three month period ended March 31, 2012. Non-accrual loans increased from $54.0 million at March 31, 2011 to $56.3 million at March 31, 2012, but declined from $60.1 million at December 31, 2011. In addition, the Company has $28.1 million in loans in the coastal North Carolina region which are collateralized by properties that have seen significant declines in value. The Company has evaluated these loans in determining its allowance for loan losses as of March 31, 2012, and has determined that its exposure to loss on these loans is either mitigated by the values of the underlying collateral or addressed by our current allowance for loan losses. At March 31, 2012, impaired loans, which include non-accrual loans, troubled debt restructuring and other impaired notes, were $90.4 million. Of these loans, $30.4 million have specific loss allowances that aggregate $5.9 million. Improved loan trends led us to decrease our allowance for loan losses to 3.34% of gross loans at March 31, 2012 as compared to 3.51% as of December 31, 2011. Management believes that the allowance is adequate to absorb probable losses inherent in the loan portfolio.

Non-Interest Income. Non-interest income for the first quarter ended March 31, 2012 decreased $179,000 to $1.2 million from $1.4 million for the same period ended March 31, 2011, primarily due to lower loan participation premiums, and lower income from bank-owned life insurance. Changes to our merchant program caused both non-interest income and non-interest expense to decline by over $100,000, offsetting each other and leaving a net $11,000 reduction to net income.

Non-Interest Expenses. Non-interest expense totaled $6.8 million for the quarters ended March 31, 2012 and 2011. Our full time equivalent employees decreased to 195 at March 31, 2012 from 206 at March 31, 2011. Reduction of staff and other cost cutting initiatives resulted in lower expenses, but increased collections expenses, insurance and professional fees, offset the reduction of other expenses. Further cost cutting efforts are underway for 2012, such as the closure of our Sanford office in May 2012.

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

Asset Quality

Past due and nonaccrual loans as of March 31, 2012 and December 31, 2011, were
as follows (in thousands):

                                              March 31,     December 31,
                                                2012            2011
Nonaccrual loans:
Commercial and industrial                    $     575     $        779
Commercial construction and land development    27,332           29,538
Commercial real estate                          14,370           14,830
Residential construction                         1,346            1,469
Residential mortgage                            12,635           13,466
Consumer                                            48               59
Total nonaccrual loans                       $  56,306     $     60,141

Foreclosed assets:
Commercial construction and land development $   7,670     $      6,863
Commercial real estate                           1,959            2,183
Residential construction                           854              837
Residential mortgage                             2,733            2,276
Total foreclosed assets                      $  13,216     $     12,159

Past due 90 days or more and still accruing:
Commercial and industrial                    $       -     $          -
Business credit cards                               32               25
Commercial construction and land development         -                -
Commercial real estate                               -                -
Residential construction                             -                -
Residential mortgage                                 -                -
Consumer                                             -                -
Consumer credit cards                                7               35
Total past due 90 days and still accruing    $      39     $         60

Total nonperforming assets                   $  69,561     $     72,360

Nonaccrual loans to gross loans                   9.72 %          10.00 %
Nonperforming assets to total assets              7.44 %           7.89 %
Allowance coverage of nonperforming loans        34.40 %          35.12 %

Non-accrual loans as a percentage of gross loans has decreased to 9.72% as of March 31, 2012 compared to 10.00% as of December 31, 2011. The allowance for loan losses as a percentage of non-accrual loans has decreased to 34.40% as of March 31, 2012 compared to 35.12% as of December 31, 2011. The primary reason for the decline in this coverage ratio is due to the increasing amount of loans being reviewed for specific impairment, but with no related allowance recorded either because a deficiency has been charged off or a because there is no identified deficiency. These loans totaled $60.1 million as of March 31, 2012 compared to $58.7 million as of December 31, 2011, a 2.3% increase. The allowance for loan losses on the loans reviewed collectively as part of the Bank's ASC 450 analysis has decreased from $11.4 million as of December 31, 2011 to $11.2 million as of March 31, 2012, but the amount of loans reviewed as part of this analysis has decreased $2.6 million over the same period.

Loans are classified as a troubled debt restructuring ("TDR") when, for economic or legal reasons related to the debtor's financial difficulties, the bank grants a concession to the debtor that would not otherwise be considered. Generally, these loans are restructured due to a borrower's inability to repay or meet the contractual obligations under the loan, which predominantly occurs because of cash flow problems. We only restructure loans for borrowers in financial difficulty that demonstrate the willingness

and capacity to repay the loan under reasonable terms and where the Bank has sufficient protection provided by the cash flow potential of the underlying collateral or business. We may grant concessions by (1) forgiving principal or interest, (2) reducing the stated interest rate to a below market rate, (3) deferring principal payments, (4) changing repayment terms from amortizing to interest only, (5) extending the repayment period, or (6) accepting a change in terms based on a bankruptcy plan.

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

All TDRs are considered to be impaired and are evaluated as such in the allowance calculation. The allowance for loan losses allocated to performing TDRs totaled $1.0 million and $1.4 million at March 31, 2012 and December 31, 2011, respectively. The allowance for loan losses allocated to nonperforming TDRs totaled $982,000 and $1.3 million at March 31, 2012 and December 31, 2011, respectively.

                                              March 31, 2012      December 31, 2011
Performing TDRs:
Commercial industrial                        $            359    $               360
Commercial construction and land development              965                  1,631
Commercial real estate                                  3,768                  4,910
Residential construction                                  165                    165
Residential mortgage                                    4,561                  3,728
Consumer                                                   13                     15
Total performing TDRs                        $          9,831    $            10,809



                                              March 31, 2012     December 31, 2011
Nonperforming TDRs:
Commercial industrial                        $           217    $               315
Commercial construction and land development          19,931                 18,357
Commercial real estate                                 7,794                  7,395
Residential construction                                 339                    345
Residential mortgage                                   6,757                  7,470
Consumer                                                   6                      8
Total nonperforming TDRs                     $        35,044    $            33,890

Other impaired loans are loans which are currently performing and are not included as nonaccrual or restructured loans above, but about which we have serious doubts as to the borrower's ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or restructured loans, so they are evaluated individually by management in assessing the adequacy of our allowance for loan losses. At March 31, 2012, we identified 185 loans totaling $35.4 million as other impaired loans.

At March 31, 2012 there were 190 foreclosed properties valued at a total of $13.2 million and 313 nonaccrual loans totaling $56.3 million. At December 31, 2011, there were 163 foreclosed properties valued at a total of $12.2 million and 357 nonaccrual loans totaling $60.1 million.

The gross interest income that would have been recorded for non-performing loans for the quarter ended March 31, 2012 and for the year ended December 31, 2011, was approximately $1.7 million and $12.4 million, respectively. The amount of interest recognized on other impaired loans and performing TDRs during the first three months of 2012 was approximately $41,000 and

$29,000, respectively. In addition, the Company has $28.1 million in loans in the coastal North Carolina region which are collateralized by properties that have seen significant declines in value. The Company has evaluated these loans in determining its allowance for loan losses as of March 31, 2012, and has determined that its exposure to loss on these loans is either mitigated by the values of the underlying collateral or reflected in our current allowance for loan losses.

The following table summarizes the Bank's allocation of allowance for loan losses at March 31, 2012, and December 31, 2011 (in thousands, except ratios):

                                            March 31, 2012                   December 31, 2011
                                                      % of Total                           % of Total
                                        Amount         Loans (1)           Amount           Loans (1)
Commercial and industrial            $     2,343            12 %     $      2,730                13 %
Commercial construction and land
development                                8,785            45 %            8,799                41 %
Commercial real estate                     2,673            14 %            3,800                18 %
Residential construction                     375             2 %              740                 4 %
Residential mortgage                       4,773            25 %            4,630                22 %
Consumer                                     412             2 %              413                 2 %
Other                                         22             - %               29                 - %
Total                                $    19,383           100 %     $     21,141               100 %

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

A summary of the allowance for the three months ended March 31, 2012 and 2011 is as follows (in thousands):

                                                 Three Months Ended
                                                     March 31,
                                                 2012          2011

Balance, beginning of period                  $  21,141     $ 22,100
Provision for loan losses                          (247 )      2,631
Allowance before net (charge-offs) recoveries    20,894       24,731

Loans charged-off                                 2,033        2,949
Recoveries                                          522          343
Net (charge-offs) recoveries                     (1,511 )     (2,606 )

Balance, end of period                        $  19,383     $ 22,125

The following table summarizes the Bank's loan loss experience for the three months ended March 31, 2012 and 2011 (amounts in thousands, except ratios):

                                                               Three Months Ended
                                                                   March 31,
                                                             2012              2011

Balance at beginning of period                          $      21,141     $     22,100

Charge-offs:
Commercial and industrial                                         227              728
Business credit cards                                              22                -
Commercial construction and land development                    1,173            1,041
Commercial real estate                                            340              288
Residential construction                                            -              241
Residential mortgage                                              151              509
Consumer                                                          113               61
Consumer credit card                                                7               81
Total charge-offs                                               2,033            2,949
Recoveries:
Commercial and industrial                                          26              165
. . .