Exhibit
13





Annual
Report to Stockholders for the Fiscal Year Ended December 31,
2009





2009
Annual Report





First
South Bancorp





TABLE
OF CONTENTS





Letter
      to Stockholders
                  
                  2Selected
      Consolidated Financial Information and Other Data
                  
                  3Management's
      Discussion and Analysis of Financial Condition and Results of
      Operation
                  
                  4Report
      of Independent Registered Public Accounting Firm
                  
                  17Consolidated
      Statements of Financial Condition
                  
                  18Consolidated
      Statements of Operations
                  
                  19Consolidated
      Statements of Changes in Stockholders' Equity
                  
                  20Consolidated
      Statements of Cash Flows
                  
                  21Notes
      to Consolidated Financial Statements
                  
                  22Board
      of Directors
                  
                  41Executive
      Officers
                  
                  41Area
      Executives and Subsidiary Executives
                  
                  41City
      Executives
                  
                  41First
      South Bank Office Locations
                  
                  42Stockholder
      Information
                  
                  43Comparative
      Stock Performance Graph
                  
                  44





MISSION
STATEMENT





"Our
mission is to become the premier community bank in eastern North Carolina. We
will enhance shareholder value by serving the personal and business needs of our
markets, providing superior customer service, investing in the communities that
we serve, and enriching the lives of our employees."





LETTER
TO STOCKHOLDERS





To Our
Stockholders:





On behalf
of First South Bancorp (“First South”) and its wholly owned subsidiary, First
South Bank (“Bank”), we are pleased to provide you our 2009 Annual
Report.





First
South earned net income of $7.0 million in 2009 compared to $11.0 million earned
in 2008.  Diluted earnings per share were $0.72 per share for 2009
versus $1.12 per share for 2008.  At December 31, 2009, our total
assets were $829.9 million; net loans and leases receivable $658.7 million; cash
and investments $127.3 million; deposits and borrowings $736.2 million;
stockholders’ equity $86.2 million and the allowance for credit losses was $13.7
million, representing 2.04% of loans outstanding. During 2009, we recorded $7.2
million of provisions for credit losses necessary to replenish net charge-offs
and strengthen the allowance for credit losses.  Our net interest
margin to average earning assets of 4.12% and our efficiency ratio of 57.63% for
fiscal 2009 places us in the top portion of our peer group in margin production
and operating efficiency.





The
significance of our 2009 earnings has been the Bank’s ability of managing its
net interest margin, managing its credit risk, maintaining adequate liquidity
levels and maintaining a consistent level of fee and service charge income from
both loan and deposit products and services.  We accomplished this
during one of the deepest economic recessions and lowest interest rate
environments in the banking sector’s history. We are working diligently with our
customers to assist them through these extraordinary times.





We
welcome news from economists that the current recession may begin
easing.  However, the current economic environment continues to
present a challenging credit environment for both our customers and the banking
industry.  As we address and manage through these challenges, we
remain focused on long-term strategies.  These strategies include
remediating problem assets, maintaining adequate levels of capital and
liquidity, improving efficiency in our operations, building core customer
relationships and improving our franchise value along with shareholder
value.  First South remains profitable, continues to maintain a strong
capital position in excess of the well-capitalized regulatory guidelines, and
combined with strengthening of the allowance for credit losses should enhance
our future earnings as recessionary economic conditions substantially improve.
Additionally, after careful review and consideration, First South determined not
to participate in the U.S. Treasury’s TARP program.





Based on
our strong capital position, your Board of Directors continued the quarterly
dividend payments during 2009 by declaring four quarterly cash dividends
totaling $0.80 per share. This resulted in a 111.1% dividend payout ratio to our
shareholders. Future dividends will depend upon the Company’s financial
condition, earnings, equity structure, capital needs, regulatory requirements
and economic conditions.





Each year
I compliment the performance of our dedicated and professional staff and 2009 is
no exception. We appreciate the quality of their work and are proud of their
many accomplishments achieved during this most challenging year. They are
committed to providing our customers the highest possible standards of
service.  We will continue to invest in our employees, which will
ultimately result in better service to our customers and enhance both our
franchise and shareholder value.





Each
member of your Board of Directors, along with our officers and employees, join
me in thanking you for supporting First South Bancorp.  As always, we
welcome your comments or suggestions and we look forward to your continued
support.





Sincerely,/s/
      Tom VannTom
      VannPresident
      andChief
      Executive Officer


2


SELECTED
CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA
 
 At or For the Years Ended December
      31,2009
                                            
                                            
                                            2008
                                            
                                            
                                            2007
                                            
                                            
                                            2006
                                            
                                            
                                            2005(dollars
      in thousands, except per share data)Selected Financial Condition
      DataTotal
      assets
                                            
                                            
                                            $
                                            829,891
                                            
                                            
                                            $
                                            875,855
                                            
                                            
                                            $
                                            909,288
                                            
                                            
                                            $
                                            910,548
                                            
                                            
                                            $
                                            834,234Loans
      receivable, net
                                            
                                            
                                            
                                            658,656
                                            
                                            
                                            
                                            744,731
                                            
                                            
                                            
                                            765,083
                                            
                                            
                                            
                                            761,437
                                            
                                            
                                            
                                            708,929Cash
      and investment securities
                                            
                                            
                                            
                                            30,045
                                            
                                            
                                            
                                            63,284
                                            
                                            
                                            
                                            73,094
                                            
                                            
                                            
                                            82,258
                                            
                                            
                                            
                                            74,771Mortgage-backed
      securities
                                            
                                            
                                            
                                            97,239
                                            
                                            
                                            
                                            32,827
                                            
                                            
                                            
                                            39,120
                                            
                                            
                                            
                                            36,729
                                            
                                            
                                            
                                            22,702Deposits
                                            
                                            
                                            
                                            688,511
                                            
                                            
                                            
                                            716,427
                                            
                                            
                                            
                                            761,370
                                            
                                            
                                            
                                            800,188
                                            
                                            
                                            
                                            733,753Borrowings
                                            
                                            
                                            
                                            47,690
                                            
                                            
                                            
                                            62,868
                                            
                                            
                                            
                                            52,377
                                            
                                            
                                            
                                            21,450
                                            
                                            
                                            
                                            22,098Stockholders'
      equity
                                            
                                            
                                            
                                            86,214
                                            
                                            
                                            
                                            87,821
                                            
                                            
                                            
                                            86,035
                                            
                                            
                                            
                                            78,797
                                            
                                            
                                            
                                            68,190Selected Operations DataInterest
      income
                                            
                                            
                                            $
                                            49,060
                                            
                                            
                                            $
                                            59,364
                                            
                                            
                                            $
                                            70,078
                                            
                                            
                                            $
                                            67,752
                                            
                                            
                                            $
                                            53,176Interest
      expense
                                            
                                            
                                            
                                            16,094
                                            
                                            
                                            
                                            23,317
                                            
                                            
                                            
                                            29,111
                                            
                                            
                                            
                                            25,607
                                            
                                            
                                            
                                            15,464Net
      interest income
                                            
                                            
                                            
                                            32,966
                                            
                                            
                                            
                                            36,047
                                            
                                            
                                            
                                            40,967
                                            
                                            
                                            
                                            42,145
                                            
                                            
                                            
                                            37,712Provision
      for credit losses
                                            
                                            
                                            
                                            7,180
                                            
                                            
                                            
                                            4,044
                                            
                                            
                                            
                                            350
                                            
                                            
                                            
                                            933
                                            
                                            
                                            
                                            1,711Noninterest
      income
                                            
                                            
                                            
                                            10,960
                                            
                                            
                                            
                                            10,084
                                            
                                            
                                            
                                            10,137
                                            
                                            
                                            
                                            9,259
                                            
                                            
                                            
                                            8,207Noninterest
      expenses
                                            
                                            
                                            
                                            25,345
                                            
                                            
                                            
                                            24,165
                                            
                                            
                                            
                                            22,911
                                            
                                            
                                            
                                            22,207
                                            
                                            
                                            
                                            21,132Income
      before income taxes
                                            
                                            
                                            
                                            11,401
                                            
                                            
                                            
                                            17,922
                                            
                                            
                                            
                                            27,843
                                            
                                            
                                            
                                            28,264
                                            
                                            
                                            
                                            23,076Income
      taxes
                                            
                                            
                                            
                                            4,365
                                            
                                            
                                            
                                            6,934
                                            
                                            
                                            
                                            10,840
                                            
                                            
                                            
                                            11,072
                                            
                                            
                                            
                                            8,947Net
      income
                                            
                                            
                                            $
                                            7,036
                                            
                                            
                                            $
                                            10,988
                                            
                                            
                                            $
                                            17,003
                                            
                                            
                                            $
                                            17,192
                                            
                                            
                                            $
                                            14,129Per Share DataEarnings per share -
      basic
                                            (1)
                                            
                                            $
                                            0.72
                                            
                                            
                                            $
                                            1.13
                                            
                                            
                                            $
                                            1.71
                                            
                                            
                                            $
                                            1.77
                                            
                                            
                                            $
                                            1.49Earnings per share -
      diluted
                                            (1)
                                            
                                            
                                            0.72
                                            
                                            
                                            
                                            1.12
                                            
                                            
                                            
                                            1.70
                                            
                                            
                                            
                                            1.72
                                            
                                            
                                            
                                            1.41Dividends per
      share
                                            (1)
                                            
                                            
                                            0.80
                                            
                                            
                                            
                                            0.80
                                            
                                            
                                            
                                            0.76
                                            
                                            
                                            
                                            0.68
                                            
                                            
                                            
                                            0.53Selected Financial Ratios and Other
      DataPerformance
      Ratios:Return
      on average assets
                                            
                                            
                                            
                                            0.81
                                            %
                                            
                                            
                                            1.22
                                            %
                                            
                                            
                                            1.87
                                            %
                                            
                                            
                                            1.93
                                            %
                                            
                                            
                                            1.78
                                            %Return
      on average equity
                                            
                                            
                                            
                                            7.98
                                            
                                            
                                            
                                            12.53
                                            
                                            
                                            
                                            20.34
                                            
                                            
                                            
                                            23.45
                                            
                                            
                                            
                                            21.92Interest
      rate spread
                                            
                                            
                                            
                                            4.04
                                            
                                            
                                            
                                            4.18
                                            
                                            
                                            
                                            4.63
                                            
                                            
                                            
                                            4.94
                                            
                                            
                                            
                                            5.04Net
      interest margin
                                            
                                            
                                            
                                            4.12
                                            
                                            
                                            
                                            4.30
                                            
                                            
                                            
                                            4.80
                                            
                                            
                                            
                                            5.05
                                            
                                            
                                            
                                            5.11Average
      earning assets/average interest bearing liabilities
                                            
                                            
                                            
                                            117.90
                                            
                                            
                                            
                                            117.77
                                            
                                            
                                            
                                            120.41
                                            
                                            
                                            
                                            119.20
                                            
                                            
                                            
                                            118.66Noninterest
      expense/average assets
                                            
                                            
                                            
                                            2.92
                                            
                                            
                                            
                                            2.68
                                            
                                            
                                            
                                            2.53
                                            
                                            
                                            
                                            2.50
                                            
                                            
                                            
                                            2.67Efficiency
      ratio
                                            
                                            
                                            
                                            57.63
                                            
                                            
                                            
                                            52.31
                                            
                                            
                                            
                                            44.99
                                            
                                            
                                            
                                            43.14
                                            
                                            
                                            
                                            45.95Dividend
      payout ratio
                                            
                                            
                                            
                                            111.11
                                            
                                            
                                            
                                            70.80
                                            
                                            
                                            
                                            44.44
                                            
                                            
                                            
                                            38.42
                                            
                                            
                                            
                                            35.87Quality
      Ratios:Nonperforming
      assets/total assets
                                            
                                            
                                            
                                            2.50
                                            %
                                            
                                            
                                            2.59
                                            %
                                            
                                            
                                            1.01
                                            %
                                            
                                            
                                            0.37
                                            %
                                            
                                            
                                            0.27
                                            %Nonperforming
      loans/total loans
                                            
                                            
                                            
                                            1.51
                                            
                                            
                                            
                                            1.98
                                            
                                            
                                            
                                            0.97
                                            
                                            
                                            
                                            0.35
                                            
                                            
                                            
                                            0.31Allowance
      for credit losses/total loans
                                            
                                            
                                            
                                            2.04
                                            
                                            
                                            
                                            1.58
                                            
                                            
                                            
                                            1.27
                                            
                                            
                                            
                                            1.29
                                            
                                            
                                            
                                            1.29Provision
      for credit losses/total loans
                                            
                                            
                                            
                                            1.07
                                            
                                            
                                            
                                            0.53
                                            
                                            
                                            
                                            0.05
                                            
                                            
                                            
                                            0.12
                                            
                                            
                                            
                                            0.24Capital
      Ratios and Other Data:Equity/total
      assets, end of period
                                            
                                            
                                            
                                            10.39
                                            %
                                            
                                            
                                            10.03
                                            %
                                            
                                            
                                            9.46
                                            %
                                            
                                            
                                            8.65
                                            %
                                            
                                            
                                            8.18
                                            %Average
      equity/average assets
                                            
                                            
                                            
                                            10.17
                                            
                                            
                                            
                                            9.72
                                            
                                            
                                            
                                            9.21
                                            
                                            
                                            
                                            8.24
                                            
                                            
                                            
                                            8.13Full
      service offices
                                            
                                            
                                            
                                            28
                                            
                                            
                                            
                                            28
                                            
                                            
                                            
                                            29
                                            
                                            
                                            
                                            26
                                            
                                            
                                            
                                            26Loans
      serviced for others
                                            
                                            
                                            $
                                            289,324
                                            
                                            
                                            $
                                            255,510
                                            
                                            
                                            $
                                            254,671
                                            
                                            
                                            $
                                            245,633
                                            
                                            
                                            $
                                            260,632
 
 (1)
Adjusted for three-for-two stock split on May 25, 2006.


3


MANAGEMENT'S
DISCUSSION AND ANALYSIS


OF
FINANCIAL CONDITION AND RESULTS OF OPERATION





General.First South
Bancorp, Inc. (the "Company") was formed to issue common stock, owning 100% of
First South Bank (the "Bank") and operating through the Bank a commercial
banking business; therefore, this discussion and analysis of consolidated
financial condition and results of operation relates primarily to the
Bank.  The business of the Bank consists principally of attracting
deposits from the general public and using them to originate secured and
unsecured commercial and consumer loans, permanent mortgage and construction
loans secured by single-family residences and other loans.  The Bank's
earnings depend primarily on its net interest income, the difference between
interest earned on interest earning assets and interest paid on interest-bearing
liabilities.  The volume of noninterest income and noninterest
expenses also impacts the Bank’s earnings.





Prevailing
economic conditions, competition, as well as federal and state regulations,
affect the operations of the Bank.  The Bank's cost of funds is
influenced by interest rates paid on competing investments, rates offered on
deposits by other financial institutions in the Bank's market area and by
general market interest rates.  Lending activities are affected by the
demand for financing of real estate and various types of commercial, consumer
and mortgage loans, and by the interest rates offered on such
financing.  The Bank's business emphasis is to operate as a
well-capitalized, profitable and independent community oriented financial
institution dedicated to providing quality customer service and meeting the
financial needs of the communities it serves. The Bank believes it has been
effective in serving its customers because of its ability to respond quickly and
effectively to customer needs and inquiries.  The Bank's ability to
provide these services has been enhanced by the stability of the Bank's senior
management team.





The
Company's common stock is listed and trades on the NASDAQ Global Select Market
under the symbol FSBK.





Liquidity
and Capital Resources.Liquidity
generally refers to the Bank's ability to generate adequate amounts of cash to
meet its funding needs.  Adequate liquidity guarantees sufficient
funds are available to meet deposit withdrawals, fund loan commitments, maintain
adequate reserve requirements, pay operating expenses, provide funds for debt
service, pay dividends to stockholders, and meet other general
commitments.  The Bank maintains its liquidity position under policy
guidelines based on liquid assets in relationship to deposits and short-term
borrowings.  The Bank's primary sources of funds are customer
deposits, loan principal and interest payments, proceeds from loan and
securities sales, and advances from the Federal Home Loan Bank of Atlanta (the
"FHLB"). While maturities and scheduled amortization of loans are predictable
sources of funds, deposit flows and loan prepayments are influenced by interest
rates, economic conditions and local competition.  The Bank’s primary
investing activity is originating commercial, consumer and mortgage loans, lease
financing receivables and purchases and sales of investment
securities.  The Bank’s primary financing activities are attracting
checking, certificate, savings deposits, repurchase agreements, obtaining FHLB
advances and payment of dividends.





The
levels of cash and cash equivalents depend on the Bank's operating, financing,
lending and investing activities during any given period.  Cash and
cash equivalents increased to $29.6 million at December 31, 2009, from $26.7
million at December 31, 2008.  The Bank has other sources of liquidity
if a need for additional funds arises.  Investment and mortgage-backed
securities available for sale totaled $97.1 million at December 31, 2009,
compared to $68.6 million at December 31, 2008. During the years ended December
31, 2009 and 2008, the Bank sold or exchanged real estate loans of $109.8
million and $41.1 million, respectively.  Borrowings consisting of
FHLB advances, junior subordinated debentures and retail repurchase agreements
were $47.7 million at December 31, 2009, compared to $62.9 million at December
31, 2008.  The Bank has pledged its FHLB Atlanta stock and certain
loans as collateral for actual or potential FHLB advances.  The Bank
has minimum credit availability with the FHLB of 20% of the Bank’s total
assets.  The Bank had $154.0 million of credit available with the FHLB
at December 31, 2009, compared to $125.1 million at December 31,
2008.





The
Company had $10.3 million of junior subordinated debentures at December 31, 2009
and 2008, respectively, issued through a private placement pooled trust
preferred securities offering by First South Preferred Trust I, a Delaware
statutory trust.  The trust preferred securities bear interest at
three-month LIBOR plus 2.95% payable quarterly.  They have a 30-year
maturity and were first redeemable, in whole or in part, on or after September
30, 2008, with certain exceptions.  For regulatory purposes, the $10.0
million total of trust preferred securities qualifies as Tier 1 capital for the
Company and the Bank, to the extent such proceeds have been invested in the Bank
and the Company.  Proceeds from the trust preferred securities were
used by the statutory trust to purchase junior subordinated debentures issued by
the Company.  See Note 20 of the “Notes to Consolidated Financial
Statements” for additional information.




4




As a
North Carolina chartered commercial bank and a Federal Deposit Insurance
Corporation (the "FDIC") insured institution, the Bank is required to meet
various state and federal regulatory capital standards. The Bank's total
regulatory capital was $88.3 million at December 31, 2009, compared to $90.1
million at December 31, 2008.  The North Carolina Commissioner of
Banks (the “Commissioner”) requires the Bank to maintain a capital surplus of
not less than 50% of common capital stock.  The FDIC requires the Bank
to meet a minimum leverage capital requirement of Tier 1 capital (consisting of
retained earnings and common stockholders' equity, less any intangible assets)
to assets ratio of at least 4%, and a total capital to risk-weighted assets
ratio of 8%, of which 4% must be in the form of Tier 1 capital.  The
Bank was in compliance with all regulatory capital requirements at December 31,
2009 and 2008.  See Note 11 of the “Notes to Consolidated Financial
Statements” for a description of the Bank’s actual regulatory capital amounts
and ratios as of December 31, 2009 and 2008.





Stockholders'
equity was $86.2 million at December 31, 2009, compared to $87.8 million at
December 31, 2008. Net income was $7.0 million for fiscal 2009, compared to
$11.0 million for fiscal 2008.  There were 9,742,296 shares of common
stock outstanding at December 31, 2009, net of 1,511,926 treasury
shares.





Contractual
Obligations and Commitments.In the normal
course of business there are various outstanding contractual obligations of the
Company that will require future cash outflows.  In addition, there
are commitments and contingent liabilities, such as commitments to extend
credit, which may or may not require future cash outflows.  Table 1
below reflects contractual obligations of the Company outstanding as of December
31, 2009.





Table
1 – Contractual Obligations and Commitments





Payments Due by PeriodLess Than
                
                
                
                
                
                
                
                
                OverContractual Obligations
                
                Total
                
                
                1 Year
                
                
                1-3 Years
                
                
                4-5 Years
                
                
                5 Years(In thousands)Borrowed
      money
                
                $
                37,380
                
                
                $
                25,000
                
                
                $
                12,380
                
                
                $
                -
                
                
                $
                -Junior
      subordinated debentures
                
                
                10,310
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                10,310Lease
      obligations
                
                
                1,535
                
                
                
                482
                
                
                
                747
                
                
                
                284
                
                
                
                22Deposits
                
                
                688,511
                
                
                
                649,236
                
                
                
                38,268
                
                
                
                1,007
                
                
                
                -Total
      contractual cash obligations
                
                $
                737,736
                
                
                $
                674,718
                
                
                $
                51,395
                
                
                $
                1,291
                
                
                $
                10,332





Amount of Commitment Expiration Per
      PeriodTotalAmounts
                    
                    
                    Less
      than
                    
                    
                    
                    
                    
                    
                    
                    
                    OverOther Commitments
                    
                    Committed
                    
                    
                    1 Year
                    
                    
                    1-3 Years
                    
                    
                    4-5 Years
                    
                    
                    5 Years(In
      thousands)Commitments
      to originate loans
                    
                    $
                    47,338
                    
                    
                    $
                    39,162
                    
                    
                    $
                    8,176
                    
                    
                    $
                    -
                    
                    
                    $
                    -Undrawn
      balances on lines of credit andundrawn
      balances on credit reserves
                    
                    
                    49,756
                    
                    
                    
                    1,004
                    
                    
                    
                    3,654
                    
                    
                    
                    6,029
                    
                    
                    
                    39,069Standby
      letters of credit
                    
                    
                    1,007
                    
                    
                    
                    1,007
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
      other commitments
                    
                    $
                    98,101
                    
                    
                    $
                    41,173
                    
                    
                    $
                    11,830
                    
                    
                    $
                    6,029
                    
                    
                    $
                    39,069





In the
normal course of business, the Company may enter into purchase agreements for
goods or services.  In management’s opinion, the dollar amount of such
agreements at December 31, 2009 is not material and has not been included in
Table 1 above. See Notes 5, 6, 9 and 14 of the “Notes to Consolidated Financial
Statements” for additional information.




Asset/Liability
Management.The Bank strives
to maintain consistent net interest income and reduce its exposure to adverse
changes in interest rates by matching the terms to repricing of its
interest-sensitive assets and liabilities.  Factors beyond the Bank's
control, such as market interest rates and competition, may also impact interest
income and interest expense.  The Bank's net interest income will
generally increase when interest rates rise over an extended period of time, and
conversely, will decrease when interest rates decline.  The Bank can
significantly influence its net interest income by controlling the increases and
decreases in its interest income and interest expense, which are primarily
caused by changes in market interest rates.  See Table 2 below for
additional information on the effects of net interest income caused by changes
in interest rates.




5





Interest
rate risk and trends, liquidity and capital ratio requirements are reported to
the Board of Directors (the “Board”) on a regular basis.  The Board
reviews the maturities of the Bank's assets and liabilities and establishes
policies and strategies designed to regulate the flow of funds and to coordinate
the sources, uses and pricing of such funds.  The first priority in
structuring and pricing assets and liabilities is to maintain an acceptable
interest rate spread while reducing the net effects of changes in interest
rates.  The Bank's management is responsible for administering the
policies and determinations of the Board with respect to the Bank's asset and
liability goals and strategies.





A primary
component in managing interest rate risk is based on the volume of interest
sensitive assets such as commercial loans, consumer loans and lease financing
receivables.  The Bank had $620.6 million of commercial loans,
consumer loans and lease receivables at December 31, 2009, compared to $710.4
million at December 31, 2008.  The Bank had $6.5 million of loans held
for sale at December 31, 2009, compared to $5.6 million at December 31,
2008.  Depending on conditions existing at a given time, the Bank may
sell fixed-rate residential mortgage loans in the secondary
market.  In managing its portfolio of investment securities, a
majority of investment  and mortgage-backed securities are held as
available for sale, allowing the Bank to sell a security in a timely manner
should an immediate liquidity need arise. The Bank had $97.1 million of
investment and mortgage-backed securities classified as available for sale at
December 31, 2009, compared to $68.6 million at December 31, 2008.





Market
Risk.Market risk
reflects the risk of economic loss resulting from changes in market prices and
interest rates. The risk of loss can be reflected in diminished current market
values and/or reduced potential net interest income in future periods. Market
risk arises primarily from interest rate risk inherent in lending and deposit
taking activities. The Bank does not maintain a trading account for any class of
financial instruments, nor does it engage in hedging activities or purchase
high-risk derivative instruments.  The Bank is also not subject to
foreign currency exchange risk or commodity price risk.





The Bank
considers interest rate risk to be its most significant market risk, which could
potentially have the greatest impact on operating earnings.  Interest
rate risk is measured by computing estimated changes in net interest income and
the net portfolio value ("NPV") of its cash flows from assets, liabilities and
off-balance sheet items in the event of a range of assumed changes in market
interest rates. The Bank's exposure to interest rates is reviewed on a quarterly
basis by management and the Board. Exposure to interest rate risk is measured
with the use of interest rate sensitivity analysis to determine the change in
NPV in the event of hypothetical changes in interest rates, while interest rate
sensitivity gap analysis is used to determine the repricing characteristics of
assets and liabilities. If estimated changes to NPV and net interest income are
not within the limits established by the Board, it may direct management to
adjust the Bank's asset and liability mix to bring interest rate risk within
Board approved limits.





NPV
represents the market value of portfolio equity and is equal to the market value
of assets minus the market value of liabilities, with adjustments made for
off-balance sheet items. The interest rate sensitivity analysis assesses the
potential loss in risk sensitive instruments in the event of sudden and
sustained 1% to 3% increases and decreases in market interest rates. With the
Federal Reserve’s current policy of continuing to hold interest rates at
historical low levels, it is not foreseeable that interest rates can decline
farther. In this extraordinary interest rate environment, rates would be driven
below zero if downward rate environment assumptions were run. Any data produced
by these assumptions would not be reliable. Therefore, the Bank will not run any
downward rate assumptions until interest rates increase. The Board has adopted
an interest rate risk policy that establishes maximum increases in NPV of 19%,
39% and 60% and maximum decreases in NPV of 19%, 37% and 54% in the event of
sudden and sustained 1% to 3% increases or decreases in market interest rates.
Table 2 below presents the Bank's projected changes in NPV and net interest
income before provision for credit losses, only in the event of sudden and
sustained increases in market interest rates for the various rate shock levels
at December 31, 2009. At December 31, 2009, the Bank's estimated changes in NPV
and net interest income were within the targets established by the
Board.





Table
2 - Projected Change in NPV and Net Interest Income





Net Portfolio Value
                  
                  
                  Net Interest Income Before PCLChange in Rates
                  
                  Amount
                  
                  
                  Change
                  
                  
                  % Change
                  
                  
                  Amount
                  
                  
                  Change
                  
                  
                  % Change(Dollars
      in thousands)+
      300 bp
                  
                  $
                  101,140
                  
                  
                  $
                  (16,163
                  )
                  
                  
                  (13.8
                  )%
                  
                  $
                  38,270
                  
                  
                  $
                  (290
                  )
                  
                  
                  (1.2
                  )%+
      200 bp
                  
                  
                  105,092
                  
                  
                  
                  (12,211
                  )
                  
                  
                  (10.4
                  )
                  
                  
                  38,391
                  
                  
                  
                  (169
                  )
                  
                  
                  (0.4
                  )+
      100 bp
                  
                  
                  110,860
                  
                  
                  
                  (6,443
                  )
                  
                  
                  (5.5
                  )
                  
                  
                  38,530
                  
                  
                  
                  (30
                  )
                  
                  
                  (0.1
                  )Base
                  
                  
                  117,303
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  38,560
                  
                  
                  
                  -
                  
                  
                  
                  -




6




The NPV
calculation is based on the net present value of discounted cash flows utilizing
market prepayment assumptions. Computations of prospective effects of
hypothetical interest rate changes are based on numerous assumptions, including
relative levels of market interest rates, loan prepayments and deposit decay
rates, and should not be relied upon as indicative of actual results. Further,
the computations do not contemplate any actions the Bank may undertake in
response to changes in interest rates.





Certain
shortcomings are inherent in the method of analysis presented in Table 2. For
example, although certain assets and liabilities may have similar maturities to
repricing, they may react in differing degrees to changes in market interest
rates. The interest rates on certain types of assets and liabilities may
fluctuate in advance of changes in market interest rates, while interest rates
on other types may lag behind changes in market rates. Certain assets, such as
adjustable-rate loans, have features that restrict changes in interest rates on
a short-term basis and over the life of the asset. In addition, the proportion
of adjustable-rate loans in the Bank's portfolio could decrease in future
periods due to refinance activity if market interest rates remain at or decrease
below current levels. Further, in the event of a change in interest rates,
prepayment and early withdrawal levels would likely deviate from those assumed
in the table. Also, the ability of many borrowers to repay their adjustable-rate
debt may decrease in the event of an increase in interest rates.





In
addition, the Bank uses interest sensitivity gap analysis to monitor the
relationship between the maturity and repricing of its interest-earning assets
and interest-bearing liabilities, while maintaining an acceptable interest rate
spread. Interest sensitivity gap is defined as the difference between the amount
of interest-earning assets maturing or repricing within a specific time period
and the amount of interest-bearing liabilities maturing or repricing within that
time period. A gap is considered positive when the amount of interest-sensitive
assets exceeds the amount of interest-sensitive liabilities, and is considered
negative when the amount of interest-sensitive liabilities exceeds the amount of
interest-sensitive assets. Generally, during a period of rising interest rates,
a negative gap would adversely affect net interest income, while a positive gap
would result in an increase in net interest income. Conversely, during a period
of falling interest rates, a negative gap would result in an increase in net
interest income, while a positive gap would negatively affect net interest
income. The Bank's goal is to maintain a reasonable balance between exposure to
interest rate fluctuations and earnings.





Rate/Volume
Analysis.  Net interest income can also be analyzed in terms of
the impact of changing interest rates on average interest-earning assets and
average interest-bearing liabilities, and the changing volume or amount of these
assets and liabilities.





Table 3
below represents the extent to which changes in interest rates and changes in
the volume of average interest-earning assets and average interest-bearing
liabilities have affected the Company's interest income and interest expense
during the periods indicated.  For each category of average
interest-earning asset and average interest-bearing liability, information is
provided on changes attributable to:  (i) changes in volume (changes
in volume multiplied by old rate); (ii) changes in rate (change in rate
multiplied by old volume); (iii) changes in rate-volume (changes in rate
multiplied by the changes in volume); and (iv) net change (total of the previous
columns).





Analysis
of Net Interest Income.  Net interest
income primarily represents the difference between income derived from
interest-earning assets and interest expense on interest-bearing
liabilities.  Net interest income is affected by both the difference
between the yield on earning assets and the average cost of funds ("interest
rate spread"), and the relative volume of interest-earning assets,
interest-bearing liabilities and noninterest-bearing deposits.





Table 4
below sets forth certain information relating to the Company's Statements of
Financial Condition and Statements of Operations for the years ended December
31, 2009, 2008, and 2007, reflecting the yield on average earning assets and the
average cost of funds for the periods indicated.  Average balances are
derived from month end balances.  The Company does not believe that
using month end balances rather than average daily balances has caused any
material difference in the information presented.





The
decline in net interest income results primarily from the decline in market
interest rates and the decline in the volume of average earning
assets.  The decline in market interest rates has been significantly
influenced by the Federal Reserve’s current policy of holding interest rates at
record low levels in efforts to stimulate current economic
conditions.  The decline in the volume of earning assets has been
influenced by a slow down in loan originations due to the current recessionary
economic environment, and the current volume of nonperforming loans and other
real estate owned, as discussed below.





7




Table
3 - Rate/Volume Analysis
 
 Year Ended December 31,
                              
                              
                              Year Ended December 31,2009 vs. 2008
                              
                              
                              2008 vs. 2007Increase (Decrease) Due to
                              
                              
                              Increase (Decrease) Due to(In
      thousands)Rate/
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              Rate/Volume
                              
                              
                              Rate
                              
                              
                              Volume
                              
                              
                              Total
                              
                              
                              Volume
                              
                              
                              Rate
                              
                              
                              Volume
                              
                              
                              TotalInterest
      income:Loans
      receivable
                              
                              $
                              (3,650
                              )
                              
                              $
                              (6,769
                              )
                              
                              $
                              448
                              
                              
                              $
                              (9,971
                              )
                              
                              $
                              (375
                              )
                              
                              $
                              (9,473
                              )
                              
                              $
                              55
                              
                              
                              $
                              (9,793
                              )Investment
      securities
                              
                              
                              (1,225
                              )
                              
                              
                              (239
                              )
                              
                              
                              150
                              
                              
                              
                              (1,314
                              )
                              
                              
                              (331
                              )
                              
                              
                              (71
                              )
                              
                              
                              10
                              
                              
                              
                              (392
                              )Mortgage-backed
      securities
                              
                              
                              1,656
                              
                              
                              
                              (213
                              )
                              
                              
                              (189
                              )
                              
                              
                              1,254
                              
                              
                              
                              (126
                              )
                              
                              
                              (67
                              )
                              
                              
                              4
                              
                              
                              
                              (189
                              )Other
      interest-earning assets
                              
                              
                              320
                              
                              
                              
                              (316
                              )
                              
                              
                              (277
                              )
                              
                              
                              (273
                              )
                              
                              
                              (53
                              )
                              
                              
                              (310
                              )
                              
                              
                              23
                              
                              
                              
                              (340
                              )Total
      earning assets
                              
                              
                              (2,899
                              )
                              
                              
                              (7,537
                              )
                              
                              
                              132
                              
                              
                              
                              (10,304
                              )
                              
                              
                              (885
                              )
                              
                              
                              (9,921
                              )
                              
                              
                              92
                              
                              
                              
                              (10,714
                              )Interest
      expense:Deposits
                              
                              
                              (792
                              )
                              
                              
                              (6,072
                              )
                              
                              
                              228
                              
                              
                              
                              (6,636
                              )
                              
                              
                              (1,353
                              )
                              
                              
                              (5,313
                              )
                              
                              
                              261
                              
                              
                              
                              (6,405
                              )FHLB
      advances
                              
                              
                              (137
                              )
                              
                              
                              (21
                              )
                              
                              
                              2
                              
                              
                              
                              (156
                              )
                              
                              
                              1,404
                              
                              
                              
                              (117
                              )
                              
                              
                              (357
                              )
                              
                              
                              930Other
      interest-bearing liabilities
                              
                              
                              (186
                              )
                              
                              
                              (315
                              )
                              
                              
                              70
                              
                              
                              
                              (431
                              )
                              
                              
                              181
                              
                              
                              
                              (432
                              )
                              
                              
                              (68
                              )
                              
                              
                              (319
                              )Total
      interest-bearing liabilities
                              
                              
                              (1,115
                              )
                              
                              
                              (6,408
                              )
                              
                              
                              300
                              
                              
                              
                              (7,223
                              )
                              
                              
                              232
                              
                              
                              
                              (5,862
                              )
                              
                              
                              (164
                              )
                              
                              
                              (5,794
                              )Change
      in net interest income
                              
                              $
                              (1,784
                              )
                              
                              $
                              (1,129
                              )
                              
                              $
                              (168
                              )
                              
                              $
                              (3,081
                              )
                              
                              $
                              (1,117
                              )
                              
                              $
                              (4,059
                              )
                              
                              $
                              256
                              
                              
                              $
                              (4,920
                              )Year Ended December 31,
                              
                              
                              Year Ended December 31,2007 vs. 2006
                              
                              
                              2006 vs. 2005Increase (Decrease) Due to
                              
                              
                              Increase (Decrease) Due to(In
      thousands)Rate/
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              Rate/Volume
                              
                              
                              Rate
                              
                              
                              Volume
                              
                              
                              Total
                              
                              
                              Volume
                              
                              
                              Rate
                              
                              
                              Volume
                              
                              
                              TotalInterest
      income:Loans
      receivable
                              
                              $
                              609
                              
                              
                              $
                              1,157
                              
                              
                              $
                              11
                              
                              
                              $
                              1,777
                              
                              
                              $
                              4,544
                              
                              
                              $
                              7,610
                              
                              
                              $
                              687
                              
                              
                              $
                              12,841Investment
      securities
                              
                              
                              (51
                              )
                              
                              
                              (213
                              )
                              
                              
                              4
                              
                              
                              
                              (260
                              )
                              
                              
                              978
                              
                              
                              
                              (221
                              )
                              
                              
                              (111
                              )
                              
                              
                              646Mortgage-backed
      securities
                              
                              
                              343
                              
                              
                              
                              (8
                              )
                              
                              
                              (2
                              )
                              
                              
                              333
                              
                              
                              
                              1,181
                              
                              
                              
                              11
                              
                              
                              
                              25
                              
                              
                              
                              1,217Other
      interest-earning assets
                              
                              
                              452
                              
                              
                              
                              8
                              
                              
                              
                              16
                              
                              
                              
                              476
                              
                              
                              
                              (202
                              )
                              
                              
                              170
                              
                              
                              
                              (96
                              )
                              
                              
                              (128
                              )Total
      earning assets
                              
                              
                              1,353
                              
                              
                              
                              944
                              
                              
                              
                              29
                              
                              
                              
                              2,326
                              
                              
                              
                              6,501
                              
                              
                              
                              7,570
                              
                              
                              
                              505
                              
                              
                              
                              14,576Interest
      expense:Deposits
                              
                              
                              446
                              
                              
                              
                              3,137
                              
                              
                              
                              58
                              
                              
                              
                              3,641
                              
                              
                              
                              1,657
                              
                              
                              
                              6,877
                              
                              
                              
                              783
                              
                              
                              
                              9,317FHLB
      advances
                              
                              
                              (162
                              )
                              
                              
                              (27
                              )
                              
                              
                              7
                              
                              
                              
                              (182
                              )
                              
                              
                              192
                              
                              
                              
                              127
                              
                              
                              
                              201
                              
                              
                              
                              520Other
      interest-bearing liabilities
                              
                              
                              4
                              
                              
                              
                              41
                              
                              
                              
                              0
                              
                              
                              
                              45
                              
                              
                              
                              28
                              
                              
                              
                              270
                              
                              
                              
                              9
                              
                              
                              
                              307Total
      interest-bearing liabilities
                              
                              
                              288
                              
                              
                              
                              3,151
                              
                              
                              
                              65
                              
                              
                              
                              3,504
                              
                              
                              
                              1,877
                              
                              
                              
                              7,274
                              
                              
                              
                              993
                              
                              
                              
                              10,144Change
      in net interest income
                              
                              $
                              1,065
                              
                              
                              $
                              (2,207
                              )
                              
                              $
                              (36
                              )
                              
                              $
                              (1,178
                              )
                              
                              $
                              4,624
                              
                              
                              $
                              296
                              
                              
                              $
                              (488
                              )
                              
                              $
                              4,432


8




Table
4 - Yield/Cost Analysis
 
 Year
      Ended December 31,
                                
                                
                                Year
      Ended December 31,
                                
                                
                                Year
      Ended December 31,2009
                                
                                
                                2008
                                
                                
                                2007(Dollars
      in thousands)Average
                                
                                
                                
                                
                                
                                
                                
                                
                                Average
                                
                                
                                
                                
                                
                                
                                
                                
                                AverageAverage
                                
                                
                                
                                
                                
                                Yield/
                                
                                
                                Average
                                
                                
                                
                                
                                
                                Yield/
                                
                                
                                Average
                                
                                
                                
                                
                                
                                Yield/Balance
                                
                                
                                Interest
                                
                                
                                Cost
                                
                                
                                Balance
                                
                                
                                Interest
                                
                                
                                Cost
                                
                                
                                Balance
                                
                                
                                Interest
                                
                                
                                CostInterest
      earning assets:Loans
      receivable
                                
                                $
                                701,466
                                
                                
                                $
                                45,211
                                
                                
                                
                                6.45
                                %
                                
                                $
                                751,151
                                
                                
                                $
                                55,182
                                
                                
                                
                                7.35
                                %
                                
                                $
                                755,502
                                
                                
                                $
                                64,975
                                
                                
                                
                                8.60
                                %Investment
      securities
                                
                                
                                16,204
                                
                                
                                
                                634
                                
                                
                                
                                3.91
                                
                                
                                
                                43,685
                                
                                
                                
                                1,948
                                
                                
                                
                                4.46
                                
                                
                                
                                50,891
                                
                                
                                
                                2,340
                                
                                
                                
                                4.60Mortgage-backed
      securities
                                
                                
                                65,681
                                
                                
                                
                                3,123
                                
                                
                                
                                4.75
                                
                                
                                
                                34,827
                                
                                
                                
                                1,869
                                
                                
                                
                                5.37
                                
                                
                                
                                37,097
                                
                                
                                
                                2,058
                                
                                
                                
                                5.55Other
      interest-earning assets
                                
                                
                                17,548
                                
                                
                                
                                92
                                
                                
                                
                                0.52
                                
                                
                                
                                9,348
                                
                                
                                
                                365
                                
                                
                                
                                3.90
                                
                                
                                
                                10,102
                                
                                
                                
                                705
                                
                                
                                
                                6.98Total
      earning assets
                                
                                
                                800,899
                                
                                
                                
                                49,060
                                
                                
                                
                                6.13
                                
                                
                                
                                839,011
                                
                                
                                
                                59,364
                                
                                
                                
                                7.08
                                
                                
                                
                                853,592
                                
                                
                                
                                70,078
                                
                                
                                
                                8.21Nonearning
      assets
                                
                                
                                65,605
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                63,657
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                53,741Total
      assets
                                
                                $
                                866,504
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                902,668
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                907,333Interest
      bearing liabilities:Time
      deposits
                                
                                $
                                465,913
                                
                                
                                
                                14,148
                                
                                
                                
                                3.04
                                
                                
                                $
                                479,642
                                
                                
                                
                                19,447
                                
                                
                                
                                4.05
                                
                                
                                $
                                505,142
                                
                                
                                
                                24,343
                                
                                
                                
                                4.82Demand
      deposits
                                
                                
                                132,226
                                
                                
                                
                                264
                                
                                
                                
                                0.20
                                
                                
                                
                                147,978
                                
                                
                                
                                1,587
                                
                                
                                
                                1.07
                                
                                
                                
                                157,125
                                
                                
                                
                                3,129
                                
                                
                                
                                1.99Savings
                                
                                
                                24,921
                                
                                
                                
                                47
                                
                                
                                
                                0.19
                                
                                
                                
                                19,734
                                
                                
                                
                                61
                                
                                
                                
                                0.31
                                
                                
                                
                                18,584
                                
                                
                                
                                28
                                
                                
                                
                                0.15FHLB
      advances
                                
                                
                                41,154
                                
                                
                                
                                1,233
                                
                                
                                
                                3.00
                                
                                
                                
                                45,654
                                
                                
                                
                                1,389
                                
                                
                                
                                3.04
                                
                                
                                
                                11,246
                                
                                
                                
                                459
                                
                                
                                
                                4.08Junior
      subordinated debentures
                                
                                
                                10,310
                                
                                
                                
                                390
                                
                                
                                
                                3.78
                                
                                
                                
                                10,310
                                
                                
                                
                                658
                                
                                
                                
                                6.38
                                
                                
                                
                                10,310
                                
                                
                                
                                839
                                
                                
                                
                                8.14Repurchase
      agreements
                                
                                
                                4,775
                                
                                
                                
                                12
                                
                                
                                
                                0.25
                                
                                
                                
                                9,105
                                
                                
                                
                                175
                                
                                
                                
                                1.92
                                
                                
                                
                                6,472
                                
                                
                                
                                313
                                
                                
                                
                                4.84Total
      interest-bearing liabilities
                                
                                
                                679,299
                                
                                
                                
                                16,094
                                
                                
                                
                                2.37
                                
                                
                                
                                712,423
                                
                                
                                
                                23,317
                                
                                
                                
                                3.27
                                
                                
                                
                                708,879
                                
                                
                                
                                29,111
                                
                                
                                
                                4.11Noninterest
      bearing demand deposits
                                
                                
                                90,599
                                
                                
                                
                                0
                                
                                
                                
                                0.00
                                
                                
                                
                                92,227
                                
                                
                                
                                0
                                
                                
                                
                                0.00
                                
                                
                                
                                103,571
                                
                                
                                
                                0
                                
                                
                                
                                0.00Total
      sources of funds
                                
                                
                                769,898
                                
                                
                                
                                16,094
                                
                                
                                
                                2.09
                                
                                
                                
                                804,650
                                
                                
                                
                                23,317
                                
                                
                                
                                2.90
                                
                                
                                
                                812,450
                                
                                
                                
                                29,111
                                
                                
                                
                                3.58Other
      liabilities and stockholders'equity:Other
      liabilities
                                
                                
                                8,477
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                10,323
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                11,275Stockholders'
      equity
                                
                                
                                88,129
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                87,695
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                83,608Total
      liabilities and stockholders' equity
                                
                                $
                                866,504
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                902,668
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                907,333Net
      interest income
                                
                                
                                
                                
                                
                                $
                                32,966
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                36,047
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                40,967Interest
      rate spread (1)
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                4.04
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                4.18
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                4.63
                                %Net
      yield on earning assets (2)
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                4.12
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                4.30
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                4.80
                                %Ratio
      of earning assets to interest bearing liabilities
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                117.90
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                117.77
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                120.41
                                %
 
 (1)
              Represents
      the difference between the yield on earning assets and the average cost of
      funds.
 (2)
              Represents
      the net interest income divided by average earning
  assets.


9





Results of
Operations





Comparison of Financial Condition at
December 31, 2009 and 2008.   Total assets declined to
$829.9 million at December 31, 2009, from $875.9 million at December 31,
2008.  Average earning assets declined to $800.9 million for the year
ended December 31, 2009, from $839.0 million for the year ended December 31,
2008, reflecting the net change in the volume and mix of loan and leases
receivable and investment securities.  Earning assets were 91.8% of
total assets at December 31, 2009, compared to 92.3% at December 31,
2008.





Investment
and mortgage-backed securities increased to $97.6 million at December 31, 2009,
from $69.4 million at December 31, 2008.  There were $20.0 million of
maturities of investment securities available for sale during fiscal 2009,
compared to $13.0 million during fiscal 2008.  The Bank purchased $5.0
million of investment securities available for sale during fiscal 2009, compared
to no purchases in fiscal 2008. During fiscal 2009, the Bank sold $20.9 million
of investment securities available for sale, compared to none sold during fiscal
2008. Proceeds from investment maturities and sales are used in daily liquidity
management activities including funding borrowing maturities, deposit
withdrawals or are reinvested into new investment securities or short-term
interest bearing overnight funds.  During fiscal 2009 the Bank
securitized $75.5 million of mortgage loans held for sale into mortgage-backed
securities, compared to $3.4 million securitized during fiscal 2008. Loan
securitizations help support a more balanced sensitivity to future interest rate
changes and provide additional funds for maintaining adequate liquidity
levels.  The Bank sold no mortgage-backed securities available for
sale in fiscal 2009, compared to $4.0 million sold in fiscal 2008.





Loans and
lease receivables, net of allowance for loan and lease losses and deferred loan
fees, declined to $658.7 million at December 31, 2009 from $744.7 million at
December 31, 2008.  The Bank originates both secured and unsecured
commercial and consumer loans and adjustable rate mortgage loans to take
advantage of shorter terms to maturity and the ability to better manage exposure
to market and interest rate risk due to changes in interest
rates.  The Bank also sells selected mortgage loans in the secondary
mortgage market in order to reduce its exposure to interest rate and credit
risk, while retaining servicing to generate additional fee
income.  Loans serviced for others increased to $289.3 million at
December 31, 2009 from $255.5 million serviced at December 31,
2008.





Commercial
loans declined to $521.2 million at December 31, 2009, from $597.0 million at
December 31, 2008, reflecting the current economic slow down and a reduction in
the volume of new loan originations. During 2009, certain commercial loans were
the subject of foreclosure and transferred to other real estate owned, as
discussed below. The Bank has severely restricted originating any new
acquisition and development loans, lot loans or land loans.  The Bank
has restricted the origination of speculative construction loans, and has
limited most new construction lending to those with contracts or pre-sales
only.  Consumer loans declined to $89.6 million at December 31, 2009
from $101.8 million at December 31, 2008; while lease receivables declined to
$9.8 million at December 31, 2009 from $11.6 million at December 31, 2008.
Commercial loan, consumer loan and lease receivables originations declined to
$99.2 million during fiscal 2009, compared to $280.3 million originated during
fiscal 2008.





Residential
mortgage loans increased to $53.0 million at December 31, 2009 from $47.0
million at December 31, 2008, reflecting the net effect of principal repayments,
originations, sales and securitizations.  The Bank originated $133.6
million of held for sale residential mortgage loans during fiscal 2009, compared
to $48.9 million originated during fiscal 2008.  The Bank also
originated $31.1 million of residential mortgage loans for investors during both
fiscal 2009 and 2008, respectively. The Bank sold $34.3 million of loans held
for sale during fiscal 2009, compared to $37.7 million sold during fiscal 2008.
Loan sales also helps reduce exposure to future interest rate changes, provides
funds for new loan originations and deposit withdrawals, and supports daily
liquidity management activities.





Nonperforming
loans, including restructured loans, declined to $10.2 million at December 31,
2009, from $15.0 million at December 31, 2008. The current level of
nonperforming and restructured loans, consisting primarily of residential and
commercial real estate loans, is attributable to the current economic
environment. Downward pressure has impacted the market values of housing and
other real estate, significantly impacting property values in the Bank’s market
area and credit quality of certain borrowers. Management believes it has
thoroughly evaluated all nonperforming and restructured loans and they are
either well collateralized or adequately reserved. However, there can be no
assurance in the future that regulators, increased credit risks in the loan
portfolio, further declines in economic conditions and other factors will not
require additional fair value adjustments to the nonperforming loans. As a
result of the volume of nonperforming loans, the Bank’s unrecognized interest
declined to $471,000 at December 31, 2009, from $624,000 at December 31,
2008.  The ratio of non-performing loans to total loans was 1.5% at
December 31, 2009, compared to 2.0% at December 31, 2008.




10





Other
real estate owned increased to $10.6 million at December 31, 2009 from $7.7
million at December 31, 2008, reflecting foreclosures of certain real estate
properties, net of sales.  Other real estate owned consists of
residential and commercial properties, developed building lots and a developed
residential subdivision.  Based on fair value analysis, the Bank
believes the adjusted carrying values of these properties are representative of
their fair market values, although there can be no assurances that the ultimate
sales will be equal to or greater than the carrying values.   The
Bank recorded $2.2 million of fair value adjustments to other real estate owned
in fiscal 2009, compared to $772,000 in fiscal 2008.





Goodwill
related to prior period acquisitions was $4.2 million at December 31, 2009 and
2008, respectively, and is not amortized according to provisions of financial
accounting standards.  The unamortized balance of the Company’s
goodwill is tested for impairment annually. The Company has performed annual
impairment testing and determined there was no impairment of goodwill as of
December 31, 2009 or December 31, 2008.





Total
deposits declined to $688.5 million at December 31, 2009 from $716.4 million at
December 31, 2008.  The Bank continues to compete in its market area
for lower costing core demand deposits. During 2009 and amid intense
competition, demand accounts increased to $224.5 million at December 31, 2009
from $223.4 million at December 31, 2008.  Certificates of deposit
declined to $440.9 million at December 31, 2009 from $466.5 million at December
31, 2008.  The Bank attempts to manage its cost of deposits by
monitoring the volume and rates paid on maturing certificates of deposits in
relationship to current funding needs and market interest
rates.  During fiscal 2009, the Bank did not renew certain maturing
high rate time deposits and began repricing new and maturing time deposits at
lower rates.  The Bank has also used lower costing FHLB borrowings as
a funding source, providing an effective means of managing its overall cost of
funds, as discussed below.





Total
borrowings declined to $47.7 million at December 31, 2009 from $62.9 million at
December 31, 2008.  FHLB advances declined to $35.0 million at
December 31, 2009 from $45.0 million at December 31, 2008, as the Bank repaid
$10.0 million of fixed rate FHLB advances, which the Bank has used as a
long-term funding source.  Junior subordinated debentures were $10.3
million at December 31, 2009 and 2008, respectively.  Repurchase
agreements representing funds held in cash management accounts for commercial
banking customers declined to $2.4 million at December 31, 2009 from $7.6
million at December 31, 2008.





Stockholders'
equity declined to $86.2 million at December 31, 2009, from $87.8 million at
December 31, 2008, reflecting the net effect of annual earnings, dividend
payments, changes in accumulated other comprehensive income and a decline in the
volume of total assets.  The Company’s equity to assets ratio
increased to 10.4% at December 31, 2009, from 10.0% at December 31,
2008.  Accumulated other comprehensive income declined to $322,000 at
December 31, 2009, from $1.2 million at December 31, 2008, reflecting reduced
unrealized gains on available for sale securities, net of deferred income taxes,
primarily due to lower market interest rates.





The
Company declared a $0.20 per share quarterly cash dividend each quarter during
fiscal 2009 and 2008, totaling $0.80 per share per year,
respectively.  These cash dividend payments reflect dividend payout
ratios on basic earnings of 111.1% for fiscal 2009 and 70.8% for fiscal
2008.  Future quarterly dividends will be determined at the discretion
of the Board of Directors based upon earnings, the capital, liquidity and
financial condition of the Company, and general economic
conditions.





The
Company did not purchase any shares of its common stock during fiscal 2009,
compared to 140,241 shares purchased in fiscal 2008 through open market and
private purchases.  Shares purchased are held as treasury stock, at
cost.  Treasury shares were 1,511,926 totaling $32.2 million at
December 31, 2009, compared to 1,516,126 shares totaling $32.2 million at
December 31, 2008.  Treasury shares are used for general corporate
purposes including the exercise of stock options and funding shares for
potential future stock splits.  There were 4,200 shares issued on the
exercise of stock options during fiscal 2009, compared to 90,499 shares issued
during fiscal 2008.  No shares were tendered to pay the exercise price
of stock options exercised during fiscal 2009, compared to 20,817 shares
tendered during fiscal 2008 to pay the exercise price and income taxes incident
to stock option exercises.





Comparison
of Operating Results for the Years Ended December 31, 2009 and
2008.





General.  Net
income was $7.0 million for the year ended December 31, 2009, compared to $11.0
million for the year ended December 31, 2008.  Diluted earnings per
share were $0.72 per share for the year ended December 31, 2009, compared to
$1.12 per share for the year ended December 31, 2008.





11


The
decline in net earnings during the year ended December 31, 2009 results
primarily from a reduction in net interest income which has been significantly
impacted by lower interest rates during the comparative reporting periods;
changes in the volume of earning and non-earning assets between the respective
reporting periods; the volume of provisions for credit losses required to
replenish net charge-offs and strengthen the allowance for credit losses; and
increased FDIC insurance premiums related to increased risk-based assessment
rates and an industry wide mandatory special assessment; while being partially
offset by a decline in the cost of funds and a consistent level of non-interest
income.





The Bank
continues to face challenges resulting from the impact of the current economy on
the housing and real estate markets. The Bank continues to monitor and evaluate
all significant loans in its portfolio, and will continue to manage its credit
risk exposure in anticipation of future stabilization of the real estate market.
Management believes competition and pricing pressures will continue on both
deposits and loans into 2010. The amount and timing of any future Federal
Reserve rate adjustment remain uncertain, and may further impact the Bank if
those adjustments are significant.





Key
performance ratios are return on average assets (ROA), return on average equity
(ROE), and efficiency. ROA was .8% for fiscal 2009, compared to 1.2% for fiscal
2008, and ROE was 8.0% for fiscal 2009, compared to 12.5% for fiscal 2008. The
efficiency ratio (noninterest expenses as a percentage of net interest income
plus noninterest income) was 57.6% for fiscal 2009, compared to 52.3% for fiscal
2008. The efficiency ratio measures the proportion of net operating revenues
that are absorbed by overhead expenses.





Interest Income. Interest
income declined to $49.1 million for fiscal 2009 from $59.4 million for fiscal
2008. The decline in interest income for fiscal 2009 was significantly impacted
by current economic conditions and by lower interest rates during fiscal 2009
and 2008. It was also influenced by the decline in the volume of average earning
assets attributable to a slow down of loan originations during the comparative
periods, and the volume of nonperforming loans and other real estate owned. The
average balance of interest-earning assets declined to $800.9 million for fiscal
2009, from $839.0 million for fiscal 2008. The yield on average interest-earning
assets declined to 6.1% for fiscal 2009 from 7.1% for fiscal 2008.





Interest Expense. Interest
expense declined to $16.1 million for fiscal 2009 from $23.3 million for fiscal
2008. The decline in interest expense reflects the decline in interest rates
previously discussed and a decline in the volume of average interest-bearing
liabilities. The average balance of interest-bearing liabilities declined to
$679.3 million for fiscal 2009, from $712.4 million for fiscal 2008. The average
balance of noninterest-bearing demand deposits declined to $90.6 million for
fiscal 2009 from $92.2 million for fiscal 2008. The average cost of funds,
including noninterest-bearing deposits, declined to 2.1% for fiscal 2009, from
2.9% for fiscal 2008, reflecting the lower interest rate environment during
these reporting periods, combined with management’s efforts to control the
Bank’s funding cost.





Net Interest Income. Net
interest income declined to $33.0 million for fiscal 2009, from $36.0 million
for fiscal 2008. The decline in net interest income during fiscal 2009 is
primarily attributable to lower market interest rates and the decline in earning
assets as previously discussed. The net yield on interest-earning assets (net
interest income divided by average interest-earning assets) was 4.1% for fiscal
2009, compared to 4.3% for fiscal 2008. The Bank's interest rate spread (the
difference between the effective yield on average interest-earning assets and
the effective average cost of funds) was 4.0% for fiscal 2009, compared to 4.2%
for fiscal 2008. See “Table 3 - Rate/Volume Analysis” and “Table 4 - Yield/Cost
Analysis” above for additional information on interest income, interest expense,
net interest income, average balances and yield/cost ratios.





Provision for Credit Losses.
During fiscal 2009, the Bank provided $7.2 million for credit losses, compared
to $4.0 million in fiscal 2008. These provisions were necessary to replenish net
charge-offs of $5.4 million and $2.0 million, respectively, during fiscal 2009
and 2008, and to bring the allowance for credit losses to an appropriate level
in light of the risk inherent in the loan and lease portfolio and provide
support to the current volume of nonperforming loans as previously
discussed.





Allowance for Credit Losses.The Bank maintains general and specific allowances for loan and lease
losses and unfunded loan commitments (collectively the “allowance for credit
losses”) at levels it believes are appropriate in light of the risk inherent in
the loan and lease portfolio and in unfunded loan commitments. The Bank has
developed policies and procedures for assessing the adequacy of the allowance
for credit losses that reflect the assessment of credit risk and impairment
analysis. This assessment includes an analysis of qualitative and quantitative
trends in the levels of classified loans. In developing this analysis, the Bank
relies on estimates and exercises judgment in assessing credit risk. Future
assessments of credit risk may yield different results, depending on changes in
the qualitative and quantitative trends, which may require increases or
decreases in the allowance for credit losses.


12





The Bank
uses a variety of modeling and estimation tools for measuring credit risk and
performing impairment analysis, which is the basis used in developing the
allowance for credit losses. The Bank’s principal focus is on the adequacy of
the total allowance for credit losses. Based on the overall credit quality of
the loan and lease receivable portfolio, the Bank believes it has established
the allowance for credit losses pursuant to generally accepted accounting
principles, and has taken into account the views of its regulators and the
current economic environment. Management evaluates the information upon which it
bases the allowance for credit losses quarterly and believes their accounting
decisions remain accurate. However, there can be no assurance in the future that
regulators, increased risks in its loans and leases portfolio, changes in
economic conditions and other factors will not require additional adjustments to
the allowance for credit losses.





The
allowance for credit losses was $13.7 million at December 31, 2009, compared to
$12.0 million at December 31, 2008. The ratio of the allowance for credit losses
to total loans and leases was 2.0% at December 31, 2009, compared to 1.6% at
December 31, 2008, which the Bank believes is appropriate. See Note 1 and Note 4
of the “Notes to Consolidated Financial Statements” for additional information
about the allowance for credit losses.





Noninterest Income.
Noninterest income increased to $11.0 million for fiscal 2009, from $10.1
million for fiscal 2008. Other income consists of fees, service charges and
servicing fees earned on loans, service charges and insufficient funds fees
collected on deposit accounts, gains from loan and securities sales and other
miscellaneous income. The Bank continues to maintain a consistent level of other
income across both loan and deposit service offerings.Fees and service charges were
$7.4 million for fiscal 2009, compared to $7.8 million for fiscal 2008. Fees,
service charges earned and insufficient funds fees collected during the
respective periods are attributable to the volume of loan and deposit account
transactions and insufficient funds transactions processed during each period,
and the collection of related fees and service charges.





Gains
from mortgage loan sales increased to $1.2 million for fiscal 2009 from $587,000
for fiscal 2008. Proceeds from the sale of loans held for sale was $34.3 million
for fiscal 2009, compared to $37.7 million sold for fiscal 2008. The Bank sells
certain held for sale mortgage loans to reduce its exposure to interest rate and
credit risk, while retaining certain other held for sale mortgage loans for
future securitization into available for sale mortgage-backed securities. In
addition, the sale of mortgage loans also provides liquidity necessary to
support the Bank’s operating, financing and lending activities.





Servicing
fee income on loans serviced for others increased to $680,000 for fiscal 2009
from $658,000 for fiscal 2008. Loans serviced for others increased to $289.3
million at December 31, 2009 from $255.5 million at December 31, 2008. Gains
from the sale of investment securities held for sale was $918,000 for fiscal
2009, compared to none for fiscal 2008. The Bank sold $20.9 million of
investment securities available for sale during fiscal 2009, compared to none
sold during fiscal 2008. The Bank recorded losses from the sales of other real
estate owned of $201,000 for fiscal 2009, compared to $81,000 for fiscal 2008,
in its best efforts to convert these nonperforming assets into earning assets.
The Bank sold $10.5 million of other real estate owned during fiscal 2009,
compared to $3.9 sold during fiscal 2008.





Noninterest Expenses.
Noninterest expenses increased to $25.3 million for fiscal 2009 from $24.2
million in fiscal 2008. The largest single component of these expenses,
compensation and fringe benefits, increased to $14.1 million for fiscal 2009,
from $13.8 million in fiscal 2008. The Bank’s full-time equivalent employees
increased to 278 at December 31, 2009, from 273 at December 31, 2008. This
increase is due to converting a loan production office into a full service
branch office and the addition of key associates in the credit administration
support function.





FDIC
insurance premiums increased to $1.3 million for fiscal 2009, from $280,000 for
fiscal 2008, reflecting a mandatory $400,000 special assessment and increased
risk based assessment rates. In addition, one-time FDIC insurance assessment
credits received under the Federal Deposit Reform Act of 2005 were exhausted in
the quarter ended June 30, 2008.





Expenses
attributable to other real estate owned were $905,000 for fiscal 2009, compared
to $936,000 for fiscal 2008. Other noninterest expenses including premises and
equipment, advertising, data processing, repairs and maintenance, office
supplies, professional fees, taxes and insurance, etc., have remained relatively
flat during the respective periods.





Income Taxes. Income taxes
declined to $4.4 million for fiscal 2009, from $6.9 million for fiscal 2008. The
decline in income taxes is a direct result of the decline of pretax earnings to
$11.4 million for fiscal 2009 from $17.9 million for fiscal 2008. Changes in the
amount of income tax expense reflect changes in pretax income and expenses, the
application of permanent and temporary differences, and the income tax rates in
effect during each period. The effective income tax rate was 38.3% for fiscal
2009 and 38.7% for fiscal 2008.


13





Comparison
of Operating Results for the Years Ended December 31, 2008 and
2007.





General.Net income was $11.0
million for the year ended December 31, 2008, compared to $17.0 million for the
year ended December 31, 2007. Diluted earnings per share were $1.12 per share
for the year ended December 31, 2008 and $1.70 per share for the year ended
December 31, 2007. Return on average assets and return on average equity for
fiscal 2008 were 1.2% and 12.5%, respectively, compared to 1.9% and 20.3% for
fiscal 2007. The efficiency ratio was 52.3% for fiscal 2008, compared to 45.0%
for fiscal 2007.





Interest Income. Interest
income declined to $59.4 million for fiscal 2008 from $70.1 million for fiscal
2007. The decline in interest income during 2008 was significantly influenced by
the Federal Reserve’s 400 basis point rate cuts since December 2007. It was also
influenced by the decline in the volume of average earning assets attributable
to a slow down of loan originations in the current recessionary economy, and the
increased level of nonperforming loans and other real estate owned. The average
balance of interest-earning assets declined to $839.0 million for fiscal 2008,
from $853.6 million for fiscal 2007. The yield on average interest-earning
assets declined 7.1% for fiscal 2008 from 8.2% for fiscal 2007.





Interest Expense. Interest
expense declined to $23.3 million for fiscal 2008 from $29.1 million for fiscal
2007. The decline in interest expense also reflects the decline in interest
rates discussed above, and a decline in the volume of average interest-bearing
deposits, offset by an increase in the average volume of borrowings. The average
balance of interest-bearing liabilities increased to $712.4 million for fiscal
2008 from $708.9 million for fiscal 2007. The average balance of
noninterest-bearing demand deposits declined to $92.2 million for fiscal 2008
from $103.6 million for fiscal 2007. The average cost of funds, including
noninterest-bearing deposits, declined to 2.9% for 2008, from 3.6% for 2007,
reflecting the declining interest rate environment during fiscal 2008 and
management’s efforts to control the Bank’s funding cost.





Net Interest Income. Net
interest income declined to $36.0 million for fiscal 2008 from $41.0 million for
fiscal 2007. The decline in net interest income during 2008 is primarily
attributable to the decline in market interest rates also influenced by the
Federal Reserve’s 400 basis point rate cuts since December 2007, and the decline
in earning assets as previously discussed. The net yield on interest-earning
assets was 4.3% for fiscal 2008, compared to 4.8% for fiscal 2007. The Bank's
interest rate spread was 4.2% for fiscal 2008, compared to 4.6% for fiscal
2007.





Provision for Credit Losses.
The Bank provided $4.0 million for credit losses during fiscal 2008, compared to
$350,000 in fiscal 2007. These provisions were necessary to replenish net
charge-offs of $2.0 million and $383,000, respectively, during fiscal 2008 and
2007, and to maintain the allowance for credit losses to an appropriate level in
light of the risk inherent in the loan and lease portfolio, to support the
current volume of nonperforming loans as previously discussed and to support the
inherent risks associated with the growth of the commercial and consumer loan
and lease receivable portfolio in recent years.





The Bank
maintains both general and specific allowances for loan and lease losses and
unfunded loan commitments (collectively the “allowance for credit losses”) based
upon management's evaluation of risk in the loan and lease receivable portfolio
and past loss experience. The allowance for credit losses was $12.0 million at
December 31, 2008, compared to $9.9 million at December 31, 2007. The ratio of
the allowance for credit losses to total loans and leases was 1.6% at December
31, 2008, compared to 1.3% at December 31, 2007, which the Bank believes is
appropriate.





Nonperforming
loans were $10.7 million at December 31, 2008, compared to $7.6 million at
December 31, 2007. The increase in nonperforming loans consisted primarily of
residential and commercial real estate credits. Restructured loans were $4.3
million at December 31, 2008, compared to none at December 31, 2007. Due to the
volume of nonperforming loans, the Bank’s unrecognized interest increased to
$624,000 at December 31, 2008, from $506,000 at December 31, 2007. The ratio of
non-performing loans to total loans was 2.0% at December 31, 2008, compared to
1.0% at December 31, 2007.





Noninterest Income.
Noninterest income was $10.1 million for both fiscal 2008 and 2007,
respectively. During fiscal 2008 and 2007, the Bank maintained a consistent
level of noninterest income across loan and deposit service offerings.Fees and service charges
increased to $7.8 million for fiscal 2008 from $7.3 million for fiscal 2007.
Fees and service charges earned and collected during these periods is
attributable to the volume of loan and deposit account transactions processed
during each period, and the ultimate collection of related fees and service
charges. Servicing fee income on loans serviced for others increased to $658,000
for fiscal 2008 from $651,000 for fiscal 2007. Loans serviced for others
increased to $255.5 million at December 31, 2008 from $254.7 million at December
31, 2007.





Gains
from mortgage loan sales increased to $587,000 for fiscal 2008 from $519,000 for
fiscal 2007. Proceeds from the sale of loans held for sale was $37.7 million for
fiscal 2008, compared $35.4 million sold for fiscal 2007. Net proceeds from loan
sales provide additional liquidity necessary to support the Bank’s operating,
financing and lending activities.


14


Noninterest Expenses.
Noninterest expenses increased to $24.2 million for fiscal 2008 from $22.9
million in fiscal 2007. The largest single component of these expenses,
compensation and fringe benefits, declined to $13.8 million for fiscal 2008 from
$14.0 million for fiscal 2007. In managing its compensation expense, the Bank
has reduced its full-time equivalent employees to 273 at December 31, 2008 from
287 at December 31, 2007. Non-interest expense in fiscal 2008 also includes
$772,000 fair value adjustments on other real estate owned and increased FDIC
insurance premiums. One-time FDIC insurance assessment credits available from
the Federal Deposit Reform Act of 2005 were used through June 2008, resulting in
FDIC insurance premiums increasing to $280,000 for fiscal 2008 from $94,000 for
fiscal 2007.





Data
processing expense has grown proportionately with the number of loan and deposit
customer accounts and the volume of transaction activity they generate. Other
noninterest expenses including advertising, premises and equipment, payroll and
other taxes, repairs and maintenance, and office expenses remained relatively
constant during fiscal 2008 and 2007.





Income Taxes. Income taxes
declined to $6.9 million for fiscal 2008 from $10.8 million for fiscal 2007. The
decline in income taxes is a direct result of the decline of pretax earnings to
$17.9 million for fiscal 2008 from $27.8 million for fiscal 2007. Changes in the
amount of income tax expense reflect changes in pretax income and expenses, the
application of permanent and temporary differences, and the income tax rates in
effect during each period. The effective income tax rate was 38.7% for fiscal
2008 and 38.9% for fiscal 2007.





Forward Looking
Statements





This
Annual Report, including the Letter to Stockholders and Management's Discussion
and Analysis of Financial Condition and Results of Operation, contains forward
looking statements that involve risk and uncertainty. The Private Securities
Litigation Reform Act of 1995 states that the disclosure of forward looking
information is desirable for investors and encourages such disclosure by
providing a safe harbor for forward looking statements by corporate
management.





In order
to comply with the terms of the safe harbor, the Company notes that its actual
results and experience may differ materially from anticipated results or other
expectations expressed in the Company's forward looking statements. Words such
as “expects”, “believes”, “estimated”, “adequate”, “scheduled” or similar
expressions are intended to identify forward looking statements. These
statements are not guarantees of future performance and involve certain risks
and uncertainties that may affect the operations, performance, development,
growth projections and results of the Company's business. Therefore, actual
future results and trends may differ materially from what may be forecast in
forward looking statements due to a variety of factors, including, but not
limited to, regional and national economic conditions, changes in levels of
market interest rates, credit and other risks of lending and investing
activities, timely development of technology enhancements for product delivery,
services and pricing, the impact of competition, customer requirements,
regulatory changes and similar matters. The Company cautions readers of this
Annual Report to not place undue reliance on forward looking statements that are
subject to influence by these risk factors and unanticipated events that could
affect the Company’s financial performance and could cause actual results for
future periods to differ materially from those anticipated or
projected.





Impact of Inflation and
Changing Prices





The
consolidated financial statements of the Company and accompanying footnotes have
been prepared in accordance with generally accepted accounting principles. They
require the measurement of financial position and operating results in terms of
historical dollars without considering the change in the relative purchasing
power of money over time and due to inflation. The impact of inflation is
reflected in the increased cost of the Bank's operations. Unlike most industrial
companies, nearly all the assets and liabilities of the Bank are monetary. As a
result, interest rates have a greater impact on the Bank's performance than do
the effects of general levels of inflation. Interest rates do not necessarily
move in the same direction or to the same extent as the price of goods and
services.





Accounting Standards
Codification





In June
2009, the Financial Accounting Standards Board (the “FASB”) issued Statement of
Financial Accounting Standards No. 168 (“SFAS No. 168”), “The FASB Accounting
Standards Codification and the Hierarchy of Generally Accepted Accounting
Principles-a replacement of FASB Statement No. 162.” The FASB Accounting
Standards Codification will become the source of authoritative U.S. GAAP
recognized by the FASB to be applied to nongovernmental entities.





See Note
1 of the “Notes to Consolidated Financial Statements” for additional information
on the Accounting Standards Codification, the respective effective and adoption
dates and impact on the Company’s consolidated financial
statements.


15


Off-Balance Sheet
Arrangements





See Note
14 of the “Notes to Consolidated Financial Statements” for a description of
financial instruments with off-balance sheet risk to which the Bank is a party
in the normal course of business to meet the financing needs of its customers
and to reduce its own exposure to fluctuations in interest rates. These
financial instruments include commitments to extend credit and involve, to
varying degrees, elements of credit and interest rate risk in excess of the
amount recognized in the consolidated balance sheet.





Controls and
Procedures





As of
December 31, 2009, management of the Company performed an evaluation, under the
supervision and with the participation of its chief executive officer and chief
financial officer, of the effectiveness of the Company’s disclosure controls and
procedures. Based on this evaluation, the Company’s chief executive officer and
chief financial officer concluded to the best of their knowledge and belief that
the Company’s disclosure controls and procedures are effective in ensuring that
information required to be disclosed by the Company in reports that it files or
submits under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission’s rules and forms. It should be noted that
the design of the Company’s disclosure controls and procedures is based in part
upon certain reasonable assumptions about the likelihood of future events, and
there can be no reasonable assurance that any design of disclosure controls and
procedures will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote, but the Company’s chief executive and
chief financial officer have concluded to the best of their knowledge and belief
that the Company’s disclosure controls and procedures are, in fact, effective at
a reasonable assurance level.





In
addition, there have been no changes in the Company’s internal control over
financial reporting (to the extent that elements of internal control over
financial reporting are subsumed within disclosure controls and procedures)
identified in connection with the evaluation described above that occurred
during the Company’s last fiscal year, that has materially affected, or is
reasonably likely to materially affect, the Company’s internal control over
financial reporting.


16








REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and the Stockholders


First
South Bancorp, Inc.


Washington,
North Carolina





We have
audited the accompanying consolidated statements of financial condition of First
South Bancorp, Inc. and Subsidiary as of December 31, 2009 and 2008, and the
related consolidated statements of operations, changes in stockholders' equity,
and cash flows for each of the years in the three-year period ended December 31,
2009. First South Bancorp, Inc. and Subsidiary’s management is responsible for
these consolidated financial statements. Our responsibility is to express an
opinion on these consolidated financial statements based on our
audits.




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




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of First South Bancorp, Inc.
and Subsidiary at December 31, 2009 and 2008 and the results of their
operations, and their cash flows each of the years in the three-year period
ended December 31, 2009 in conformity with accounting principles generally
accepted in the United States of America.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), First South Bancorp, Inc. and Subsidiary's
internal control over financial reporting as of December 31, 2009, based on
criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report dated March 8, 2010 expressed an
unqualified opinion.





/s/
Turlington and Company, L.L.P.





Lexington,
North Carolina


March 8,
2010





509
East Center Street – Post Office
Box 1697 –Lexington,
North Carolina 27293-1697


Office:
336-249-6856 –Facsimile:
336-248-8697





1338
Westgate Center Drive – Winston-Salem,
North Carolina 27103


Office:
336-765-2410 – Facsimile:
336-765-6241


www.turlingtonandcompany.com




17


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF FINANCIAL CONDITION
 December
31, 2009 and 2008





2009
                        
                        
                        2008ASSETSCash
      and due from banks
                        
                        $
                        17,758,370
                        
                        
                        $
                        20,888,676Interest-bearing
      deposits in financial institutions
                        
                        
                        11,879,794
                        
                        
                        
                        5,831,683Investment
      securities - available for sale
                        
                        
                        407,317
                        
                        
                        
                        36,563,646Mortgage-backed
      securities - available for sale
                        
                        
                        96,725,468
                        
                        
                        
                        31,995,157Mortgage-backed
      securities - held for investment
                        
                        
                        513,882
                        
                        
                        
                        832,221Loans
      receivable, netHeld
      for sale
                        
                        
                        6,548,980
                        
                        
                        
                        5,566,262Held
      for investment
                        
                        
                        652,106,538
                        
                        
                        
                        739,165,035Premises
      and equipment, net
                        
                        
                        8,539,759
                        
                        
                        
                        9,049,929Real
      estate owned
                        
                        
                        10,561,071
                        
                        
                        
                        7,710,560Federal
      Home Loan Bank of Atlanta stock, at costwhich
      approximates market
                        
                        
                        3,889,500
                        
                        
                        
                        3,658,600Accrued
      interest receivable
                        
                        
                        3,318,141
                        
                        
                        
                        3,786,760Goodwill
                        
                        
                        4,218,576
                        
                        
                        
                        4,218,576Mortgage
      servicing rights
                        
                        
                        1,278,688
                        
                        
                        
                        1,005,725Identifiable
      intangible assets
                        
                        
                        133,620
                        
                        
                        
                        165,060Income
      tax receivable
                        
                        
                        1,831,598
                        
                        
                        
                        1,679,191Prepaid
      expenses and other assets
                        
                        
                        10,179,333
                        
                        
                        
                        3,738,040Total
      assets
                        
                        $
                        829,890,635
                        
                        
                        $
                        875,855,121LIABILITIES
      AND STOCKHOLDERS' EQUITYDeposits:Demand
                        
                        $
                        224,507,362
                        
                        
                        $
                        223,365,542Savings
                        
                        
                        23,137,391
                        
                        
                        
                        26,555,881Large
      denomination certificates of deposit
                        
                        
                        224,198,974
                        
                        
                        
                        207,102,876Other
      time
                        
                        
                        216,667,331
                        
                        
                        
                        259,402,497Total
      deposits
                        
                        
                        688,511,058
                        
                        
                        
                        716,426,796Borrowed
      money
                        
                        
                        37,380,388
                        
                        
                        
                        52,558,492Junior
      subordinated debentures
                        
                        
                        10,310,000
                        
                        
                        
                        10,310,000Other
      liabilities
                        
                        
                        7,475,085
                        
                        
                        
                        8,738,808Total
      liabilities
                        
                        
                        743,676,531
                        
                        
                        
                        788,034,096Commitments
      and contingencies (Note 14)Common
      stock, $.01 par value, 25,000,000 shares authorized,11,254,222
      issued; 9,742,296 and 9,738,096shares
      outstanding, respectively
                        
                        
                        97,423
                        
                        
                        
                        97,381Additional
      paid-in capital
                        
                        
                        35,841,364
                        
                        
                        
                        35,924,426Retained
      earnings, substantially restricted
                        
                        
                        82,111,114
                        
                        
                        
                        82,867,095Treasury
      stock at cost
                        
                        
                        (32,158,074
                        )
                        
                        
                        (32,247,365
                        )Accumulated
      other comprehensive income, net
                        
                        
                        322,277
                        
                        
                        
                        1,179,488Total
      stockholders' equity
                        
                        
                        86,214,104
                        
                        
                        
                        87,821,025Total
      liabilities and stockholders' equity
                        
                        $
                        829,890,635
                        
                        
                        $
                        875,855,121




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


18


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 Years
Ended December 31, 2009, 2008 and 2007





2009
                
                
                2008
                
                
                2007Interest
      incomeInterest
      and fees on loans
                
                $
                45,211,260
                
                
                $
                55,182,193
                
                
                $
                64,975,487Interest
      and dividends on investments and
      deposits
                
                
                3,848,639
                
                
                
                4,181,602
                
                
                
                5,102,761Total
      interest income
                
                
                49,059,899
                
                
                
                59,363,795
                
                
                
                70,078,248Interest
      expenseInterest
      on deposits
                
                
                14,459,345
                
                
                
                21,095,044
                
                
                
                27,499,996Interest
      on borrowings
                
                
                1,244,664
                
                
                
                1,563,978
                
                
                
                771,976Interest
      on junior subordinated debentures
                
                
                389,677
                
                
                
                657,576
                
                
                
                839,110Total
      interest expense
                
                
                16,093,686
                
                
                
                23,316,598
                
                
                
                29,111,082Net
      interest income before provision for credit losses
                
                
                32,966,213
                
                
                
                36,047,197
                
                
                
                40,967,166Provision
      for credit losses
                
                
                7,180,000
                
                
                
                4,043,600
                
                
                
                350,000Net
      interest income
                
                
                25,786,213
                
                
                
                32,003,597
                
                
                
                40,617,166Other
      incomeFees
      and service charges
                
                
                7,377,019
                
                
                
                7,750,195
                
                
                
                7,341,240Loan
      servicing fees
                
                
                679,673
                
                
                
                658,073
                
                
                
                651,358Gain
      (loss) on sale of real estate, net
                
                
                (200,732
                )
                
                
                (80,542
                )
                
                
                49,644Gain
      on sale of mortgage loans
                
                
                1,197,029
                
                
                
                586,571
                
                
                
                519,361Gain
      on sale of mortgage-backed securities
                
                
                -
                
                
                
                97,537
                
                
                
                -Gain
      on sale of investment securities
                
                
                917,866
                
                
                
                -
                
                
                
                -Other
      income
                
                
                988,865
                
                
                
                1,071,726
                
                
                
                1,575,171Total
      other income
                
                
                10,959,720
                
                
                
                10,083,560
                
                
                
                10,136,774General
      and administrative expensesCompensation
      and fringe benefits
                
                
                14,118,842
                
                
                
                13,750,085
                
                
                
                13,973,012Federal
      insurance premiums
                
                
                1,253,627
                
                
                
                280,372
                
                
                
                94,349Premises
      and equipment
                
                
                1,823,628
                
                
                
                1,969,006
                
                
                
                1,938,555Advertising
                
                
                123,513
                
                
                
                112,758
                
                
                
                125,490Payroll
      and other taxes
                
                
                1,327,449
                
                
                
                1,246,743
                
                
                
                1,308,248Data
      processing
                
                
                2,452,593
                
                
                
                2,630,821
                
                
                
                2,524,983Amortization
      of intangible assets
                
                
                488,602
                
                
                
                434,260
                
                
                
                394,508Other
                
                
                3,756,547
                
                
                
                3,740,652
                
                
                
                2,551,831Total
      general and administrative expenses
                
                
                25,344,801
                
                
                
                24,164,697
                
                
                
                22,910,976Income
      before income taxes
                
                
                11,401,132
                
                
                
                17,922,460
                
                
                
                27,842,964Income
      taxes
                
                
                4,365,296
                
                
                
                6,934,640
                
                
                
                10,839,737NET
      INCOME
                
                
                7,035,836
                
                
                
                10,987,820
                
                
                
                17,003,227Other
      comprehensive income (loss), net of taxes
                
                
                (857,211
                )
                
                
                802,984
                
                
                
                955,829Comprehensive
      income
                
                $
                6,178,625
                
                
                $
                11,790,804
                
                
                $
                17,959,056Net
      income per common shareBasic
                
                $
                0.72
                
                
                $
                1.13
                
                
                $
                1.71Diluted
                
                $
                0.72
                
                
                $
                1.12
                
                
                $
                1.70




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


19


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 Years
Ended December 31, 2009, 2008 and 2007


Common
                  stock
                
                
                Additional
                  paid-in
                  capital
                
                
                Retained
                  earnings,
                  substantially
                  restricted
                
                
                Treasury
                  stock
                
                
                Accumulated
                  other
                  comprehensive
                  income
                  (loss), net
                
                
                TotalBalance,
      December 31, 2006
                
                $
                97,881
                
                
                $
                38,165,536
                
                
                $
                70,217,380
                
                
                $
                (29,104,894
                )
                
                $
                (579,325
                )
                
                $
                78,796,578Net
      income
                
                
                -
                
                
                
                -
                
                
                
                17,003,227
                
                
                
                -
                
                
                
                -
                
                
                
                17,003,227Other
      comprehensive income, net
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                955,829
                
                
                
                955,829Exercise
      of stock options
                
                
                3,031
                
                
                
                (4,740,120
                )
                
                
                -
                
                
                
                6,093,153
                
                
                
                -
                
                
                
                1,356,064Tax
      benefit, stock options exercised
                
                
                -
                
                
                
                2,430,435
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                2,430,435Shares
      traded to exercise options
                
                
                (383
                )
                
                
                822,209
                
                
                
                -
                
                
                
                (1,148,545
                )
                
                
                -
                
                
                
                (326,719
                )Acquisition
      of treasury shares
                
                
                (2,442
                )
                
                
                -
                
                
                
                -
                
                
                
                (6,719,834
                )
                
                
                -
                
                
                
                (6,722,276
                )Stock
      based compensation
                
                
                -
                
                
                
                83,764
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                83,764Dividends
      ($.76 per share)
                
                
                -
                
                
                
                -
                
                
                
                (7,541,580
                )
                
                
                -
                
                
                
                -
                
                
                
                (7,541,580
                )Balance,
      December 31, 2007
                
                
                98,087
                
                
                
                36,761,824
                
                
                
                79,679,027
                
                
                
                (30,880,120
                )
                
                
                376,504
                
                
                
                86,035,322Net
      income
                
                
                -
                
                
                
                -
                
                
                
                10,987,820
                
                
                
                -
                
                
                
                -
                
                
                
                10,987,820Other
      comprehensive income, net
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                802,984
                
                
                
                802,984Exercise
      of stock options
                
                
                905
                
                
                
                (1,682,353
                )
                
                
                -
                
                
                
                1,926,743
                
                
                
                -
                
                
                
                245,295Tax
      benefit, stock options exercised
                
                
                -
                
                
                
                452,317
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                452,317Shares
      traded to exercise options
                
                
                (208
                )
                
                
                355,505
                
                
                
                -
                
                
                
                (449,979
                )
                
                
                -
                
                
                
                (94,682
                )Acquisition
      of treasury shares
                
                
                (1,403
                )
                
                
                -
                
                
                
                -
                
                
                
                (2,844,009
                )
                
                
                -
                
                
                
                (2,845,412
                )Stock
      based compensation
                
                
                -
                
                
                
                37,133
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                37,133Dividends
      ($.80 per share)
                
                
                -
                
                
                
                -
                
                
                
                (7,799,752
                )
                
                
                -
                
                
                
                -
                
                
                
                (7,799,752
                )Balance,
      December 31, 2008
                
                
                97,381
                
                
                
                35,924,426
                
                
                
                82,867,095
                
                
                
                (32,247,365
                )
                
                
                1,179,488
                
                
                
                87,821,025Net
      income
                
                
                -
                
                
                
                -
                
                
                
                7,035,836
                
                
                
                -
                
                
                
                -
                
                
                
                7,035,836Other
      comprehensive loss, net
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (857,211
                )
                
                
                (857,211
                )Exercise
      of stock options
                
                
                42
                
                
                
                (62,804
                )
                
                
                -
                
                
                
                89,291
                
                
                
                -
                
                
                
                26,529Tax
      benefit, stock options exercised
                
                
                -
                
                
                
                4,482
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                4,482Shares
      traded to exercise options
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Acquisition
      of treasury shares
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Stock
      based compensation
                
                
                -
                
                
                
                (24,740
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (24,740
                )Dividends
      ($.80 per share)
                
                
                -
                
                
                
                -
                
                
                
                (7,791,817
                )
                
                
                -
                
                
                
                -
                
                
                
                (7,791,817
                )Balance,
      December 31, 2009
                
                $
                97,423
                
                
                $
                35,841,364
                
                
                $
                82,111,114
                
                
                $
                (32,158,074
                )
                
                $
                322,277
                
                
                $
                86,214,104




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


20





FIRST SOUTH BANCORP, INC. ANDSUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 Years
Ended December 31, 2009, 2008 and 2007








2009
                                
                                
                                2008
                                
                                
                                2007Operating activities:Net
      income
                                
                                $
                                7,035,836
                                
                                
                                $
                                10,987,820
                                
                                
                                $
                                17,003,227Adjustments
      to reconcile net income to netcash
      provided by (used in) operating activitiesProvision
      for credit losses
                                
                                
                                7,180,000
                                
                                
                                
                                4,043,600
                                
                                
                                
                                350,000Depreciation
                                
                                
                                818,398
                                
                                
                                
                                879,832
                                
                                
                                
                                813,510Amortization
      of intangibles
                                
                                
                                488,602
                                
                                
                                
                                434,260
                                
                                
                                
                                394,508Accretion
      of discounts on securities, net
                                
                                
                                (63,241
                                )
                                
                                
                                7,383
                                
                                
                                
                                (12,849
                                )Deferred
      income taxes
                                
                                
                                (1,298,149
                                )
                                
                                
                                (862,742
                                )
                                
                                
                                (438,860
                                )(Gain)
      loss on disposal of premises and equipment
                                
                                
                                (5,566
                                )
                                
                                
                                1,540
                                
                                
                                
                                (157,247
                                )(Gain)
      loss on sale of other real estate owned
                                
                                
                                200,732
                                
                                
                                
                                80,542
                                
                                
                                
                                (49,644
                                )Gain
      on loans held for sale and mortgage-backed
      securities
                                
                                
                                (1,197,029
                                )
                                
                                
                                (684,108
                                )
                                
                                
                                (519,361
                                )Gain
      on sale of investment securities available for sale
                                
                                
                                (917,866
                                )
                                
                                
                                -
                                
                                
                                
                                -Stock
      based compensation (income) expense
                                
                                
                                (24,740
                                )
                                
                                
                                37,133
                                
                                
                                
                                83,764Originations
      of loans held for sale, net
                                
                                
                                (109,618,929
                                )
                                
                                
                                (38,549,148
                                )
                                
                                
                                (23,668,607
                                )Proceeds
      from sale of loans held for sale
                                
                                
                                34,347,308
                                
                                
                                
                                37,686,012
                                
                                
                                
                                35,374,932Other
      operating activities
                                
                                
                                (4,018,215
                                )
                                
                                
                                3,011,045
                                
                                
                                
                                (459,284
                                )Net
      cash provided by (used in) operating activities
                                
                                
                                (67,072,859
                                )
                                
                                
                                17,073,169
                                
                                
                                
                                28,714,089Investing
      activities:Proceeds
      from maturities of investment securitiesavailable
      for sale
                                
                                
                                20,000,000
                                
                                
                                
                                13,000,000
                                
                                
                                
                                9,000,000Proceeds
      from sale of investment securities available for sale
                                
                                
                                20,917,866
                                
                                
                                
                                -
                                
                                
                                
                                -Purchases
      of investment securities available for sale
                                
                                
                                (5,000,000
                                )
                                
                                
                                -
                                
                                
                                
                                (500,000
                                )Proceeds
      from principal repayments and sales ofmortgage-backed
      securities available for sale
                                
                                
                                10,558,314
                                
                                
                                
                                10,155,010
                                
                                
                                
                                4,579,831Proceeds
      from principal repayments ofmortgage-backed
      securities held for investment
                                
                                
                                318,339
                                
                                
                                
                                459,541
                                
                                
                                
                                370,778Originations
      of loans held for investment, netof
      principal repayments
                                
                                
                                64,040,224
                                
                                
                                
                                3,476,254
                                
                                
                                
                                (23,651,034
                                )Proceeds
      from disposal of premises and equipment
                                
                                
                                11,813
                                
                                
                                
                                -
                                
                                
                                
                                515,843Proceeds
      from disposal of other real estate owned
                                
                                
                                10,543,291
                                
                                
                                
                                3,883,475
                                
                                
                                
                                676,965Purchases
      of FHLB stock
                                
                                
                                (230,900
                                )
                                
                                
                                (448,500
                                )
                                
                                
                                (1,276,800
                                )Purchases
      of premises and equipment
                                
                                
                                (314,475
                                )
                                
                                
                                (497,902
                                )
                                
                                
                                (1,707,363
                                )Net
      cash provided by (used in) investing activities
                                
                                
                                120,844,472
                                
                                
                                
                                30,027,878
                                
                                
                                
                                (11,991,780
                                )Financing
      activities:Net
      decrease in deposit accounts
                                
                                
                                (27,915,738
                                )
                                
                                
                                (44,942,787
                                )
                                
                                
                                (38,818,898
                                )Net
      increase (decrease) in FHLB borrowings
                                
                                
                                (10,000,000
                                )
                                
                                
                                10,000,000
                                
                                
                                
                                29,000,000Purchase
      of treasury shares
                                
                                
                                -
                                
                                
                                
                                (2,845,412
                                )
                                
                                
                                (6,722,276
                                )Proceeds
      from exercise of stock options, net of tax benefit
                                
                                
                                31,011
                                
                                
                                
                                602,930
                                
                                
                                
                                3,459,780Cash
      paid for dividends
                                
                                
                                (7,790,977
                                )
                                
                                
                                (7,715,777
                                )
                                
                                
                                (7,342,722
                                )Net
      change in repurchase agreements
                                
                                
                                (5,178,104
                                )
                                
                                
                                491,071
                                
                                
                                
                                1,927,474Net
      cash used in financing activities
                                
                                
                                (50,853,808
                                )
                                
                                
                                (44,409,975
                                )
                                
                                
                                (18,496,642
                                )Increase
      (decrease) in cash and cash equivalents
                                
                                
                                2,917,805
                                
                                
                                
                                2,691,072
                                
                                
                                
                                (1,774,333
                                )Cash
      and cash equivalents, beginning of year
                                
                                
                                26,720,359
                                
                                
                                
                                24,029,287
                                
                                
                                
                                25,803,620Cash
      and cash equivalents, end of year
                                
                                $
                                29,638,164
                                
                                
                                $
                                26,720,359
                                
                                
                                $
                                24,029,287





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


21


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 As
of And For The Years Ended December 31, 2009, 2008 and 2007





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES





ORGANIZATION
AND NATURE OF OPERATIONS





First
South Bancorp, Inc. (the "Company") is a bank holding company incorporated under
the laws of the Commonwealth of Virginia. First South Bank (the "Bank"), the
wholly owned subsidiary of the Company, is organized and incorporated under the
laws of the State of North Carolina. The Federal Reserve Board regulates the
Company and the Federal Deposit Insurance Corporation and the North Carolina
Office of the Commissioner of Banks regulate the Bank.





The
consolidated financial statements include the accounts of the Company, the Bank,
and the Bank's wholly owned subsidiary, First South Leasing, LLC. All
significant intercompany balances and transactions have been eliminated in
consolidation.





The
Company follows accounting principles generally accepted in the United States of
America and general practices within the financial services industry as
summarized below:





USE
OF ESTIMATES





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





CASH
AND CASH EQUIVALENTS





Cash and
cash equivalents include highly liquid assets such as cash on hand, non-interest
bearing deposits and amounts in clearing accounts due from correspondent banks
and clearing balances required to be maintained with the Federal
Reserve.  At times, the Bank places deposits with high credit quality
financial institutions in amounts which may be in excess of federally insured
limits.





INVESTMENTS
AND MORTGAGE-BACKED SECURITIES





Investments
in certain securities are classified into three categories and accounted for as
follows: (1) debt securities that the entity has the positive intent and the
ability to hold to maturity are classified as held for investment (“HFI”) and
reported at amortized cost; (2) debt and equity securities that are bought and
held principally for the purpose of selling them in the near term are classified
as trading securities and reported at fair value, with unrealized gains and
losses included in earnings; (3) debt and equity securities not classified as
either held for investment securities or trading securities are classified as
available for sale (“AFS”) securities and reported at fair value, with
unrealized gains and losses excluded from earnings and reported as accumulated
other comprehensive income, a separate component of equity.





A decline
in the market value of any AFS or HFI security below cost that is deemed to be
other-than-temporary results in a reduction in carrying amount to fair value.
The impairment is charged to earnings and a new cost basis for the security is
established. To determine whether an impairment is other-than-temporary, the
Company considers whether it has the ability and intent to hold the investment
until a market price recovery and considers whether evidence indicating the cost
of the investment is recoverable outweighs evidence to the contrary. Evidence
considered in this assessment includes the reasons for the impairment, the
severity and duration of the impairment, changes in value subsequent to
year-end, and forecasted performance of the investee.





Premiums
and discounts on debt securities are recognized as adjustments to interest
income using the interest method over the period to maturity.  Gains
and losses on the sale of securities are determined using the specific
identification method. Mortgage-backed securities represent participating
interests in pools of long-term first mortgage loans. Premiums and discounts are
amortized using the interest method over the remaining period to contractual
maturity, adjusted for anticipated prepayments.


22


1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





LOANS
RECEIVABLE AND ALLOWANCE FOR CREDIT LOSSES





Loans
receivable held for investment are stated at the amount of unpaid principal,
reduced by an allowance for probable credit losses and net of deferred
origination fees. Interest on loans is accrued based on the principal amount
outstanding and is recognized using the interest method.





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





Commitment
fees to originate or purchase loans are deferred and, if the commitment is
exercised, recognized over the life of the loan as an adjustment of yield. If
the commitment expires unexercised, commitment fees are recognized in income
upon expiration of the commitment. Fees for originating loans for other
financial institutions are recognized as loan fee income.





A loan is
considered impaired, based on current information and events, if it is probable
that the Bank will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan agreement.
Uncollateralized loans are measured for impairment based on the present value of
expected future cash flows discounted at the historical effective interest rate,
while all collateral-dependent loans are measured for impairment based on the
fair value of the collateral. The Bank uses several factors in determining if a
loan is impaired. Internal asset classification procedures include a thorough
review of significant loans and lending relationships and include the
accumulation of related data. This data includes loan payment status, borrowers'
financial data and borrowers' operating factors such as cash flows, operating
income or loss, etc.





There
were $23.0 million of loans classified as impaired at December 31, 2009. The
allowance for loan losses included $5.1 million specifically provided for these
impaired loans as of December 31, 2009.  Average impaired loans were
$15.6 million for the year ended December 31, 2009. Interest income recognized
on impaired loans for the year ended December 31, 2009 was $804,000. At December
31, 2008, there were $8.2 million of loans individually or in the aggregate,
that were material to the consolidated financial statements which were defined
as impaired.





The
allowance for credit losses is increased by charges to income and decreased by
charge-offs (net of recoveries). Management's periodic evaluation of the
adequacy of the allowance is based on the Bank's past loan loss experience,
known and inherent risks in the portfolio, adverse situations that may affect
the borrower's ability to repay, the estimated value of any underlying
collateral, and current economic conditions. While management believes that it
has established the allowance in accordance with accounting principles generally
accepted in the United States of America and has taken into account the views of
its regulators and the current economic environment, there can be no assurance
that in the future the Bank's regulators or risks in its portfolio will not
require further increases in the allowance.





LOANS
HELD FOR SALE





Loans
originated and intended for sale are carried at the lower of cost or aggregate
estimated market value. Net unrealized losses are recognized as charges to
income. Gains and losses on sales of whole or participating interests in real
estate loans are recognized at the time of sale and are determined by the
difference between net sales proceeds and the Bank's carrying value of the loans
sold, adjusted for the recognition of any servicing assets
retained.





As a part
of its normal business operations, the Bank originates mortgage loans that have
been approved by secondary investors. The Bank issues a rate lock commitment to
a borrower and concurrently “locks-in” with a secondary market investor, under a
best efforts delivery mechanism. The terms of the loan are set by the secondary
investors and are transferred within a short time period of the Bank initially
funding the loan.  The Bank receives origination fees from borrowers
and servicing release premiums from investors that are recognized when the loan
is sold on the Statement of Operations in the line item “Gain on sale of
mortgage loans”.  Between the initial funding of the loans by the Bank
and subsequent purchase by the investor, the Bank carries the loans on its
Statement of Financial Condition at the lower of cost or fair market
value.


23





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





INCOME
RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS





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





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





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





MORTGAGE
SERVICING RIGHTS





When
mortgage loans, or mortgage-backed securities, are sold, the proceeds are
allocated between the related loans and the retained mortgage servicing rights
based on their relative fair values.





Servicing
assets and liabilities are amortized on a straight line basis over the average
period of estimated net servicing income (if servicing revenues exceed servicing
costs) or net servicing loss (if servicing costs exceed servicing revenues). All
servicing assets or liabilities are assessed for impairment or increased
obligation based on their fair value.





The
Company recorded amortization of mortgage servicing rights of $457,162, $402,820
and $363,068 for prepayments during the years ended December 31, 2009, 2008 and
2007, respectively. There were no impairments recognized during the years ended
December 31, 2009, 2008 and 2007.





PREMISES
AND EQUIPMENT





Premises
and equipment are stated at cost less accumulated depreciation or amortization,
if a capital lease. Depreciation and amortization are computed using the
straight-line method based on the estimated service lives of the assets. Useful
lives range from 10 to 40 years for substantially all premises and from 3 to 20
years for equipment and fixtures.





REAL
ESTATE OWNED





Assets
acquired through loan foreclosure are recorded as real estate owned at the lower
of the estimated fair value of the property less estimated costs to sell at the
date of foreclosure or the carrying amount of the loan plus unpaid accrued
interest. The carrying amount is subsequently reduced by additional allowances
which are charged to earnings if the estimated fair value declines below its
initial value plus any capitalized costs. Costs related to the improvement of
the property are capitalized, whereas costs related to holding the property are
expensed. Valuation adjustments recognized during the years ended December 31,
2009, 2008 and 2007 were $2.2 million, $772,000 and $0,
respectively.





INVESTMENT
IN FEDERAL HOME LOAN BANK STOCK





The Bank
is required to invest in Class B capital stock, par value $100, of the Federal
Home Loan Bank of Atlanta (“FHLB”).  The FHLB capital stock
requirement is based on the sum of a membership stock component totaling 20% of
the Bank’s total assets plus an activity based stock component of 4.5% of
outstanding FHLB advances.  At December 31, 2009 and 2008, the Bank
owned 38,895 and 36,586 shares of the FHLB’s capital stock, respectively. The
Bank carries this investment at cost.  Due to the redemption
provisions of the FHLB, the Company estimated that fair value equals cost and
that this investment was not impaired at December 31, 2009.


24





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





GOODWILL
AND INTANGIBLE ASSETS





Net
assets of companies acquired in purchase transactions are recorded at fair value
at the date of acquisition and, as such, the historical cost basis of individual
assets and liabilities are adjusted to reflect their fair value. Identified
intangible assets resulting from branch offices acquired in 2004 are amortized
on a straight-line basis over 10 years.  Amortization expense of
$31,440 per year was recorded for the years ended December 31, 2009, 2008 and
2007, respectively. Goodwill is not amortized, but is reviewed for potential
impairment on an annual basis at the reporting unit level. The impairment test
is performed in two phases. The first step of the goodwill impairment test, used
to identify potential impairment, compares the fair value of the reporting unit
with its carrying amount, including goodwill. If the fair value of the reporting
unit exceeds its carrying amount, goodwill of the reporting unit is considered
not impaired; however, if the carrying amount of the reporting unit exceeds its
fair value, an additional procedure must be performed. That additional procedure
compares the implied fair value of the reporting unit's goodwill with the
carrying amount of that goodwill. An impairment loss is recorded to the extent
that the carrying amount of goodwill exceeds its implied fair value. Other
intangible assets are evaluated for impairment if events and circumstances
indicate a possible impairment. Such evaluation of other intangible assets is
based on undiscounted cash flow projections.





INCOME
TAXES





As
required under accounting standards for income taxes, the Company adopted the
new standard regarding uncertain income tax positions effective January 1, 2008.
Under this new standard, the impact of an uncertain income tax position on the
income tax returns must be recognized at the largest amount that is
more-likely-than-not to be required to be recognized upon audit by the relevant
taxing authority. The standards also provide guidance on derecognition,
measurement, classification, interest and penalties, accounting for interim
periods, disclosure, and transition issues with respect to tax
positions.





As a
result of adoption of the new standard regarding uncertain income tax positions,
the Company has determined that it has no uncertain income tax positions as of
the adoption date of January 1, 2008. Also, the Company does not anticipate any
increase or decrease in unrecognized tax benefits during the next twelve months
that would result in a material change to its financial position. The Company’s
income tax returns for years ended after December 31, 2007 remain open for
examination.





The
Company includes interest and penalties in the financial statements as a
component of income tax expense. No interest or penalties are included in the
Company’s income tax expense for the years ended December 31, 2009, 2008 and
2007.





ADVERTISING





Advertising
costs are expensed as incurred. For the years ended December 31, 2009, 2008 and
2007, the Company incurred advertising expense totaling $123,513, $112,758 and
$125,490, respectively.





COMPREHENSIVE
INCOME





The
Company's other comprehensive income (loss) relates to unrealized gains (losses)
on available for sale securities. Information concerning the Company's other
comprehensive income (loss) for the years ended December 31, 2009, 2008 and 2007
is as follows:





Years
      ended December 31,2009
                
                
                2008
                
                
                2007Unrealized
      gains (losses) on securities available for sale
                
                $
                (1,416,877
                )
                
                $
                1,327,246
                
                
                $
                1,565,079Income
      tax benefit (expense)
                
                
                559,666
                
                
                
                (524,262
                )
                
                
                (609,250
                )Other
      comprehensive income (loss), net
                
                $
                (857,211
                )
                
                $
                802,984
                
                
                $
                955,829




25





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





SEGMENT
INFORMATION





The
Company follows financial accounting standards which specify guidelines for
determining its operating segments and the type and level of financial
information to be disclosed. Based on these guidelines, management has
determined that the Bank operates in one business segment, the providing of
general commercial financial services to customers located in its market areas.
The various products are those generally offered by community banks. The
allocation of Bank resources is based on overall performance of the Bank, rather
than individual branches or products.





ACCOUNTING
STANDARDS CODIFICATION





In June
2009, the Financial Accounting Standards Board (the “FASB”) issued Statement of
Financial Accounting Standards No. 168 (“SFAS No. 168”), “The FASB
Accounting Standards Codification and the Hierarchy of Generally Accepted
Accounting Principles—a replacement of FASB Statement No. 162.” The FASB
Accounting Standards Codification will become the source of authoritative U.S.
GAAP recognized by the FASB to be applied to nongovernmental entities. Following
this Statement, the FASB Board will not issue new standards in the form of
Statements, FASB Staff Positions, or Emerging Issues Task Force
Abstracts.  Instead, they will issue Accounting Standards Updates. The
Board will not consider Accounting Standards Updates as authoritative in their
own right.  Accounting Standards Updates will serve only to update the
Codification, provide background information about the guidance and provide the
basis for conclusions on the change(s) in the Codification.





This
statement replaces SFAS No. 162 and modifies the GAAP hierarchy into two levels:
authoritative and non-authoritative. This statement is effective for financial
statements issued for interim and annual periods ending after September 15,
2009. The Company adopted SFAS No. 168 on September 30, 2009, with no material
impact on its consolidated financial statements. Going forward, as the FASB
issues Accounting Standards Updates, the Company will evaluate the impact that
such updates may have on its consolidated financial statements of the Company
and will also monitor the effective dates of such updates.





2.
INVESTMENT SECURITIES





Investment
securities at December 31, 2009 and 2008 are classified as available for sale
according to management's intent and summarized as follows:


Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                unrealized
                
                
                unrealized
                
                
                marketcost
                
                
                gains
                
                
                losses
                
                
                valueDecember
      31, 2009:U.S.
      Treasury and Agency Notes
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Triangle
      Capital Corporation
                
                
                505,000
                
                
                
                -
                
                
                
                (97,683
                )
                
                
                407,317$
                505,000
                
                
                $
                -
                
                
                $
                (97,683
                )
                
                $
                407,317December
      31, 2008:U.S.
      Treasury and Agency Notes
                
                $
                34,936,759
                
                
                $
                1,283,245
                
                
                $
                -
                
                
                $
                36,220,004Triangle
      Capital Corporation
                
                
                505,000
                
                
                
                -
                
                
                
                (161,358
                )
                
                
                343,642$
                35,441,759
                
                
                $
                1,283,245
                
                
                $
                (161,358
                )
                
                $
                36,563,646





Included
in the Company’s investment securities total are equity securities consisting of
33,333 shares of restrictive common stock of Triangle Capital Corporation
(NASDAQ: TCAP) received on February 21, 2007 upon completion of a public
offering of TCAP. Prior to the public offering, the Company was a limited
partner in the Triangle Mezzanine Fund, LLLP, with an investment of $500,000. In
the public offering, TCAP acquired Triangle Mezzanine Fund, LLLP, and the
limited partners received shares of TCAP restricted common stock in amounts
equivalent to their limited investment in the Triangle Mezzanine Fund, LLLP. At
December 31, 2009, the TCAP equity securities owned by the Company had a market
value of $407,317. Unrealized loss on Triangle Capital Corporation equity
security is considered by management to be temporary.





At year
end 2009 the Bank had no remaining U.S. Treasury and Agency Notes held as
investment securities. U.S. Treasury and Agency Notes with an amortized cost of
approximately $0 and $12.8 million were pledged to secure deposits from public
entities and repurchase agreements at December 31, 2009 and 2008,
respectively.


26





3.
MORTGAGE-BACKED SECURITIES





Mortgage-backed
securities at December 31, 2009 and 2008 are classified as available for sale
according to management's intent and summarized as follows:


Gross
                          
                          
                          Gross
                          
                          
                          EstimatedAmortized
                          
                          
                          unrealized
                          
                          
                          unrealized
                          
                          
                          marketcost
                          
                          
                          gains
                          
                          
                          losses
                          
                          
                          valueDecember 31,
      2009:FHLMC PCs, maturing
      from years
      2011 to 2040
                          
                          $
                          96,095,095
                          
                          
                          $
                          1,147,242
                          
                          
                          $
                          516,869
                          
                          
                          $
                          96,725,468December
      31, 2008:FHLMC
      PCs, maturing fromyears 2009 to 2038
                          
                          $
                          31,167,477
                          
                          
                          $
                          827,680
                          
                          
                          $
                          -
                          
                          
                          $
                          31,995,157





Mortgage-backed
securities at December 31, 2009 and 2008 are classified as held for investment
according to management's intent and summarized as follows:


Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                unrealized
                
                
                unrealized
                
                
                marketcost
                
                
                gains
                
                
                losses
                
                
                valueDecember
      31, 2009:FHLMC
      PCs, maturing during 2013
                
                $
                513,882
                
                
                $
                4,574
                
                
                $
                -
                
                
                $
                518,456December
      31, 2008:FHLMC
      PCs, maturing during 2013
                
                $
                832,221
                
                
                $
                25,882
                
                
                $
                -
                
                
                $
                858,103





The
following table presents mortgage-backed securities unrealized losses and fair
values, aggregated by length of time that individual securities have been in a
continuous unrealized loss position, at December 31, 2009. There were no
mortgage-backed securities in an unrealized loss position at December 31,
2008.





2009Less
      Than 12 Months
                
                
                12
      Months or More
                
                
                TotalFair
                  value
                
                
                Unrealized
                  losses
                
                
                Fair
                  value
                
                
                Unrealized
                  losses
                
                
                Fair
                  value
                
                
                Unrealized
                  lossesSecurities
      available for sale:FHLMC
      PCs
                
                $
                49,044,596
                
                
                $
                516,869
                
                
                $
                -
                
                
                $
                -
                
                
                $
                49,044,596
                
                
                $
                516,869





Mortgage-backed
securities, classified as available for sale or held for investment, at December
31, 2009 are contractually scheduled to mature as follows:


EstimatedAmortized
                
                
                marketcost
                
                
                valueDue
      one year or less
                
                $
                -
                
                
                $
                -Due
      after one year through five years
                
                
                1,635,453
                
                
                
                1,715,601Due
      after five years through ten years
                
                
                0
                
                
                
                0Due
      after ten years
                
                
                94,973,524
                
                
                
                95,528,323Total
                
                $
                96,608,977
                
                
                $
                97,243,924





Expected
maturities may differ from contractual maturities because borrowers have the
right to call or prepay obligations with or without call or prepayment
penalties. Mortgage-backed securities with a carrying value of $0, $4,022,495
and $0 were sold during the years ended December 31, 2009, 2008 and 2007,
respectively. Mortgage-backed securities with an amortized cost of $6,182,774
and $318,321 were pledged as collateral for public deposits, repurchase
agreements and treasury tax and loan deposits at December 31, 2009 and 2008,
respectively.





27




4.
LOANS RECEIVABLE





Loans
receivable at December 31, 2009 and 2008 are summarized as follows:





2009
                
                
                2008Mortgage
      loans
                
                $
                52,960,619
                
                
                $
                46,990,010Consumer
      loans
                
                
                89,642,641
                
                
                
                101,808,252Commercial
      loans
                
                
                521,182,385
                
                
                
                597,012,445Lease
      receivables
                
                
                9,817,909
                
                
                
                11,560,539Total
                
                
                673,603,554
                
                
                
                757,371,246Less:  Allowance
      for loan losses
                
                
                (13,503,940
                )
                
                
                (11,617,706
                )Deferred loan fees, net
                
                
                (1,444,096
                )
                
                
                (1,022,243
                )Loans
      receivable, net
                
                $
                658,655,518
                
                
                $
                744,731,297





The Bank
has pledged its eligible real estate loans to collateralize actual or potential
borrowings from the Federal Home Loan Bank of Atlanta (See Note 9).





During
the years ended December 31, 2009, 2008, and 2007 the Bank exchanged loans with
outstanding principal balances of $75,485,932, $3,399,071 and $6,873,490,
respectively, with the Federal Home Loan Mortgage Corporation ("FHLMC") for
mortgage-backed securities of equal value.





The Bank
originates mortgage loans for portfolio investment or sale in the secondary
market. During the period of origination, mortgage loans are designated as
either held for sale or for investment purposes. Transfers of loans held for
sale to the investment portfolio are recorded at the lower of cost or market
value on the transfer date. Loans receivable held for sale at December 31, 2009
and 2008 are fixed rate mortgage loans with an estimated market value of
approximately $6,897,491 and $5,781,287, respectively. Net gains on sales of
loans receivable held for sale amounted to $1,197,029, $586,571 and $519,361 for
the years ended December 31, 2009, 2008 and 2007, respectively.





Activity
in the allowance for credit losses, which includes the allowance for loan and
lease losses and unfunded commitments for the years ended December 31, 2009,
2008 and 2007, is summarized as follows:





Allowance for
                  Loan and Lease
                  Losses
                
                
                Allowance for
                  Unfunded
                  Commitments
                
                
                Allowance for
                  Credit LossesBalance
      at December 31, 2006
                
                $
                9,157,597
                
                
                $
                764,940
                
                
                $
                9,922,537Provisions
      for credit losses
                
                
                712,297
                
                
                
                (362,297
                )
                
                
                350,000Loans
      charged off
                
                
                (420,717
                )
                
                
                -
                
                
                
                (420,717
                )Recoveries
                
                
                37,302
                
                
                
                -
                
                
                
                37,302Balance
      at December 31, 2007
                
                
                9,486,479
                
                
                
                402,643
                
                
                
                9,889,122Provisions
      for credit losses
                
                
                4,106,248
                
                
                
                (62,648
                )
                
                
                4,043,600Loans
      charged off
                
                
                (2,167,630
                )
                
                
                -
                
                
                
                (2,167,630
                )Recoveries
                
                
                192,609
                
                
                
                -
                
                
                
                192,609Balance
      at December 31, 2008
                
                
                11,617,706
                
                
                
                339,995
                
                
                
                11,957,701Provisions
      for credit losses
                
                
                7,279,713
                
                
                
                (99,713
                )
                
                
                7,180,000Loans
      charged off
                
                
                (5,774,831
                )
                
                
                -
                
                
                
                (5,774,831
                )Recoveries
                
                
                381,352
                
                
                
                -
                
                
                
                381,352Balance
      at December 31, 2009
                
                $
                13,503,940
                
                
                $
                240,282
                
                
                $
                13,744,222





Following
is a summary of the principal balances of loans on nonaccrual status and loans
past due over ninety days:





December
      31,2009
                  
                  2008Loans
      contractually past due over 90 days and/or on nonaccrual
      status:Mortgage
      residential
                  
                  $
                  767,141
                  
                  
                  $
                  1,211,334Consumer
      and commercial
                  
                  
                  11,170,640
                  
                  
                  
                  14,620,731Total
                  
                  $
                  11,937,781
                  
                  
                  $
                  15,832,065





For the
years ended December 31, 2009, 2008 and 2007, interest income of $470,734,
$624,265 and $505,990, respectively, was not recorded related to loans accounted
for on a nonaccrual basis.


28





5.
PREMISES AND EQUIPMENT





Premises
and equipment consist of the following:


December
      31,2009
                
                
                2008Land
                
                $
                3,102,730
                
                
                $
                3,102,730Office
      buildings and improvements
                
                
                7,703,338
                
                
                
                7,699,008Furniture,
      fixtures and equipment
                
                
                5,126,100
                
                
                
                5,020,744Vehicles
                
                
                523,965
                
                
                
                537,312Construction
      in process
                
                
                68,131
                
                
                
                -16,524,264
                
                
                
                16,359,794Less
      accumulated depreciation
                
                
                7,984,505
                
                
                
                7,309,865Total
                
                $
                8,539,759
                
                
                $
                9,049,929





The
Company leases certain branch facilities and equipment under separate agreements
that expire at various dates through December 31, 2015. Future rentals under
these leases are as follows:





2010
                  
                  $
                  482,3532011
                  
                  
                  396,8492012
                  
                  
                  349,6022013
                  
                  
                  245,3442014
                  
                  
                  38,400Thereafter
                  
                  
                  22,400Total
                  
                  $
                  1,534,948





Rental
expense of $597,146, $601,510 and $444,412 during the years ended December 31,
2009, 2008 and 2007, respectively, is included in premises and equipment expense
on the accompanying consolidated statements of operations.





6.
DEPOSITS





At
December 31, 2009, the scheduled maturities of time deposits were as
follows:





2010
                  
                  $
                  401,591,2562011
                  
                  
                  34,562,6532012
                  
                  
                  3,705,0362013
                  
                  
                  560,6532014
                  
                  
                  446,707Thereafter
                  
                  
                  -Total
      time deposits
                  
                  $
                  440,866,305





7.
EMPLOYEE BENEFIT PLANS





The
Company participated in a multi-employer defined benefit pension plan which
covered substantially all employees; however, effective January 31, 2002, the
Company's Board of Directors approved a plan to freeze the accrual of future
benefits under the plan.  Consequently, no new employees became
eligible to participate in the plan after January 31, 2002. Effective October 1,
2004, the Company withdrew from the plan. Active employees who were
participating in the plan became 100% vested on that date and could select from
a variety of benefit payment options based on their age and benefit payment
amount.





The
Company also participates in a defined contribution plan which covers
substantially all employees. During the years ended December 31, 2009, 2008 and
2007, employees may contribute from 1% to 100% of compensation, subject to an
annual maximum as determined by the Internal Revenue Code. The Company makes
matching contributions of 100% of employees' contributions up to 5% of the
employees' salaries.


29





7.
EMPLOYEE BENEFIT PLANS (Continued)





The plan
provides that employees' contributions are 100% vested at all times and the
Bank's contributions vest 25% for each year of service. The expenses related to
the Company's contributions to this plan for the years ended December 31, 2009,
2008 and 2007 were $296,142, $351,394 and $293,475, respectively. Directors
and certain officers participate in deferred compensation plans. These plans
provide for fixed payments beginning at retirement, and are earned over service
periods of up to ten years, and include provisions for deferral of current
payments. The expense related to these plans during the years ended December 31,
2009, 2008 and 2007 was $373,990, $408,303 and $449,464, respectively. The plans
include provisions for forfeitures of unvested portions of payments, and vesting
in the event of death or disability. The total liability under this plan was
$3,165,471 at December 31, 2009 and is included in other liabilities in the
accompanying consolidated statements of financial condition.





8.
STOCK-BASED COMPENSATION





The
Company had two stock-based compensation plans at December 31,
2009.  The shares outstanding are for grants under the Company’s 1997
Stock Option Plan (the “1997 Plan”) and the 2008 Equity Incentive Plan (the
“2008 Plan”) (collectively, the “Plans”). The 1997 Plan matured on April 8, 2008
and no additional options may be granted under that plan.  At December
31, 2009, the 1997 Plan had 128,270 granted unexercised shares.  On
May 22, 2008, the Shareholders of the Company approved the 2008 Plan for a term
of ten years.  At December 31, 2009, the 2008 Plan includes 43,500
granted unexercised shares and 914,500 shares available to be
granted.





Stock
options expire ten years from the date of grant and vest over service periods
ranging from one year to five years.  The Plans have a change in
control provision under which all options vest immediately if a change in
control occurs.  Options granted under the 2008 Plan are granted at
the closing sales price of the Company’s common stock on the NASDAQ Stock Market
on the date of grant. The Company settles stock option exercises with treasury
shares.





The
average fair value of options granted during the years ended December 31, 2009
and 2008 was $4.18 and $2.36, respectively.  The fair value of each
option grant is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions used for
grants during the years ended December 31, 2009, 2008 and 2007:





December
      31,Year Ended:
                      
                      2009
                      
                      
                      2008
                      
                      
                      2007Dividend
      growth rate
                      
                      
                      5.3
                      %
                      
                      
                      11.8
                      %
                      
                      
                      17
                      %Expected
      volatility
                      
                      
                      36.6
                      %
                      
                      
                      24.0
                      %
                      
                      
                      22.6
                      %Average
      risk-free interest rates
                      
                      
                      2.78
                      %
                      
                      
                      3.34
                      %
                      
                      
                      3.95
                      %Expected
      lives
                      
                      6
      years
                      
                      
                      6
      years
                      
                      
                      6
      years





A summary
of option activity under the Plans as of December 31, 2009 and 2008, and
changes during the years then ended is presented below:


Options
                                      Available
                                    
                                    
                                    Options
                                      Outstanding
                                    
                                    
                                    Price
                                    
                                    
                                    Aggregate
                                      Intrinsic
                                      ValueOutstanding
      at December 31, 2007
                                    
                                    
                                    967,652
                                    
                                    
                                    
                                    255,919
                                    
                                    
                                    $
                                    13.90
                                    
                                    
                                    $
                                    2,120,393Granted
                                    
                                    
                                    (24,000
                                    )
                                    
                                    
                                    24,000
                                    
                                    
                                    
                                    19.85Forfeited
                                    
                                    
                                    4,000
                                    
                                    
                                    
                                    (17,125
                                    )
                                    
                                    
                                    24.24Exercised
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (90,499
                                    )
                                    
                                    
                                    6.64Expired
      shares 1997 Plan
                                    
                                    
                                    (958,652
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Approved
      2008 Plan shares
                                    
                                    
                                    958,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Outstanding
      at December 31, 2008
                                    
                                    
                                    947,000
                                    
                                    
                                    
                                    172,295
                                    
                                    
                                    $
                                    17.52
                                    
                                    
                                    $
                                    (854,558
                                    )Granted
                                    
                                    
                                    (35,500
                                    )
                                    
                                    
                                    35,500
                                    
                                    
                                    
                                    11.25Forfeited
                                    
                                    
                                    3,000
                                    
                                    
                                    
                                    (31,825
                                    )
                                    
                                    
                                    20.00Exercised
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (4,200
                                    )
                                    
                                    
                                    6.32Outstanding
      at December 31, 2009
                                    
                                    
                                    914,500
                                    
                                    
                                    
                                    171,770
                                    
                                    
                                    $
                                    16.04
                                    
                                    
                                    $
                                    (985,969
                                    )




30


8.
STOCK-BASED COMPENSATION (Continued)





The net
compensation benefits credited against expense for the Plans was $24,740 for the
year ended December 31, 2009, compared to net compensation costs of $37,133
charged against income for the year ended December 31, 2008.  Total
recapture credits against compensation expense due to forfeited options were
$98,056 for the year ended December 31, 2009, compared to $35,954 for the year
ended December 31, 2008. The total income tax benefits recognized for
stock-based compensation costs were $4,482 and $452,317 for the years ended
December 31, 2009 and 2008, respectively.





Total
unrecognized compensation cost on granted unexercised shares was $172,556 at
December 31, 2009, compared to $115,129 at December 31, 2008.  That
cost is expected to be recognized over the next three years.





The total
intrinsic value of options exercised during the years ended December 31, 2009
and 2008 was $21,357 and $1,342,854, respectively.





The
following table summarizes additional information about the Company’s
outstanding options and exercisable options as of December 31, 2009, including
weighted-average remaining contractual term expressed in years ("Life") and
weighted average exercise price (“Price”):





Outstanding
                            
                            
                            ExercisableRange
      of Exercise Price
                            
                            
                            Shares
                            
                            
                            Life
                            
                            
                            Price
                            
                            
                            Shares
                            
                            
                            Price$5.50
      – 12.95
                            
                            
                            
                            68,583
                            
                            
                            
                            5.25
                            
                            
                            $
                            9.75
                            
                            
                            
                            36,083
                            
                            
                            $
                            8.36$14.97
      – 16.49
                            
                            
                            
                            36,562
                            
                            
                            
                            3.04
                            
                            
                            
                            16.10
                            
                            
                            
                            36,562
                            
                            
                            
                            16.10$16.77
      – 25.22
                            
                            
                            
                            52,375
                            
                            
                            
                            7.07
                            
                            
                            
                            20.76
                            
                            
                            
                            31,917
                            
                            
                            
                            20.78$26.17
      – 33.27
                            
                            
                            
                            14,250
                            
                            
                            
                            6.62
                            
                            
                            
                            28.81
                            
                            
                            
                            9,050
                            
                            
                            
                            28.97171,770
                            
                            
                            
                            5.45
                            
                            
                            
                            16.04
                            
                            
                            
                            113,612
                            
                            
                            
                            15.98





A summary
of nonvested option shares as of December 31, 2009 and 2008, and changes
during the years ended December 31, 2009 and 2008 is presented
below:





Year
      Ended:
                
                December
      31, 2009
                
                
                December
      31, 2008Shares
                
                
                Price
                
                
                Shares
                
                
                PriceNonvested
      at beginning of year
                
                
                43,275
                
                
                $
                22.68
                
                
                
                53,975
                
                
                $
                24.38Granted
                
                
                35,500
                
                
                
                11.25
                
                
                
                24,000
                
                
                
                19.85Forfeited
                
                
                (4,250
                )
                
                
                15.39
                
                
                
                (11,500
                )
                
                
                25.78Vested
                
                
                (16,367
                )
                
                
                22.96
                
                
                
                (23,200
                )
                
                
                22.16Nonvested
      at end of year
                
                
                58,158
                
                
                
                16.16
                
                
                
                43,275
                
                
                
                22.68





The
following table reflects the impact of stock based compensation by increasing or
reducing income before income taxes, net income, basic earnings per share and
diluted earnings per share for the years ended December 31, 2009, 2008 and
2007:





Year
      Ended December 31,2009
                
                
                2008
                
                
                2007Increased
      (reduced) net income before income taxes
                
                $
                24,739
                
                
                $
                (37,132
                )
                
                $
                (83,763
                )Increased
      (reduced) net income
                
                
                11,202
                
                
                
                (36,228
                )
                
                
                (76,843
                )Reduced
      basic earnings per share
                
                
                .00
                
                
                
                .00
                
                
                
                (.01
                )Reduced
      diluted earnings per share
                
                
                .00
                
                
                
                (.01
                )
                
                
                .00





9.
BORROWED MONEY





Borrowed
money represents advances from the FHLB and repurchase agreements. Outstanding
FHLB advances at December 31, 2009 and 2008 totaled $35.0 million and $45.0
million, respectively, and had a weighted average fixed rate of 3.04% at
December 31, 2009 and 3.01% at December 31, 2008.  At December 31,
2009, the FHLB advances consisted of $25.0 million with a scheduled maturity
date of January 29, 2010, and $10.0 million with a scheduled maturity date of
January 31, 2011.


31


9.
BORROWED MONEY (Continued)
 
 At
December 31, 2009 and 2008, repurchase agreements totaled $2,380,388 and
$7,558,492, respectively, and had a weighted average rate of 0.25% at December
31, 2009 and December 31, 2008. At December 31, 2009, repurchase agreements were
collateralized by Federal Home Loan Mortgage Corporation participation
certificates with a principal balance of $2.4 million.  The Company
has pledged all of its stock in the FHLB and certain loans secured by one to
four family residential mortgages as collateral for actual or potential
borrowings from the FHLB. At December 31, 2009 and 2008, the Company had
approximately $154.0 million and $125.1 million, respectively, of additional
credit available with the FHLB.
 
 10.
INCOME TAXES
 
 The
components of income tax expense for the years ended December 31, 2009, 2008 and
2007 are as follows:
 
 Years Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007CurrentFederal
                  
                  $
                  4,586,057
                  
                  
                  $
                  6,516,536
                  
                  
                  $
                  9,804,043State
                  
                  
                  1,077,388
                  
                  
                  
                  1,280,846
                  
                  
                  
                  1,474,5545,663,445
                  
                  
                  
                  7,797,382
                  
                  
                  
                  11,278,597DeferredFederal
                  
                  
                  (1,068,097
                  )
                  
                  
                  (709,851
                  )
                  
                  
                  (361,087
                  )State
                  
                  
                  (230,052
                  )
                  
                  
                  (152,891
                  )
                  
                  
                  (77,773
                  )(1,298,149
                  )
                  
                  
                  (862,742
                  )
                  
                  
                  (438,860
                  )Total
                  
                  $
                  4,365,296
                  
                  
                  $
                  6,934,640
                  
                  
                  $
                  10,839,737
 
 Reconciliations
of the expected income tax expense at statutory tax rates with income tax
expense reported in the statements of operations for the years ended December
31, 2009, 2008 and 2007 are as follows:
 
 Years Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007Expected
      income tax expense at 35%
                  
                  $
                  3,990,396
                  
                  
                  $
                  6,272,861
                  
                  
                  $
                  9,745,037State
      income taxes, net of federal income tax
                  
                  
                  550,768
                  
                  
                  
                  733,171
                  
                  
                  
                  907,908Other
      expenses and adjustments
                  
                  
                  (175,868
                  )
                  
                  
                  (71,392
                  )
                  
                  
                  186,792Total
                  
                  $
                  4,365,296
                  
                  
                  $
                  6,934,640
                  
                  
                  $
                  10,839,737
 
 The
components of deferred income tax assets and liabilities are as
follows:
 
 Years Ended December 31,2009
                  
                  
                  2008Deferred
      income tax assetsDeferred
      directors' fees
                  
                  $
                  543,015
                  
                  
                  $
                  548,723Allowance
      for credit losses
                  
                  
                  5,330,220
                  
                  
                  
                  4,624,544Employee
      benefits
                  
                  
                  707,344
                  
                  
                  
                  705,515Loans
      mark-to-market
                  
                  
                  210,126
                  
                  
                  
                  157,399Other
                  
                  
                  205,178
                  
                  
                  
                  265,8226,995,883
                  
                  
                  
                  6,302,003Deferred
      income tax liabilitiesDepreciation
      and amortization
                  
                  
                  2,737,419
                  
                  
                  
                  3,289,429Carrying
      value – land
                  
                  
                  395,000
                  
                  
                  
                  395,000Mortgage
      servicing rights
                  
                  
                  505,082
                  
                  
                  
                  397,261Deferred
      loan origination fees and costs
                  
                  
                  712,349
                  
                  
                  
                  845,136FHLB
      stock
                  
                  
                  -
                  
                  
                  
                  27,293Unrealized
      gain on securities available for sale
                  
                  
                  210,413
                  
                  
                  
                  770,0794,560,263
                  
                  
                  
                  5,724,198Net
      deferred income tax asset
                  
                  $
                  2,435,620
                  
                  
                  $
                  577,805
  32
 
 11.
REGULATORY CAPITAL REQUIREMENTS
 
 Dividend
payments made by the Company are subject to regulatory restrictions under
Federal Reserve Board policy as well as to limitations under applicable
provisions of Virginia corporate law. The Federal Reserve Board may prohibit a
bank holding company from paying any dividends if the holding company's bank
subsidiary is classified as "undercapitalized." Under Virginia law, dividends
may be paid out of surplus or, if there is no surplus, out of net profits for
the fiscal year in which the dividend is declared and for the preceding fiscal
year. Furthermore, under FDIC regulations, the Bank is prohibited from making
any capital distributions if, after making the distribution, the Bank would
have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1
risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less
than 4.0%.
 
 The Bank
is subject to various regulatory capital requirements administered by the
federal and state banking agencies. Failure to meet minimum capital requirements
can initiate certain mandatory and possibly additional
discretionary  actions by regulators that, if undertaken, could have a
direct material effect on the Bank's financial statements. Quantitative measures
established by regulation to ensure capital adequacy require the Bank to
maintain minimum amounts and ratios, as set forth in the table below. Management
believes, as of December 31, 2009, that the Bank meets all capital adequacy
requirements to which it is subject. The Company’s most significant asset is its
investment in First South Bank. Consequently, the information concerning capital
ratios is essentially the same for the Company and the Bank.
 
 As of
December 31, 2009, the most recent notification from the FDIC categorized the
Bank as well capitalized under the regulatory framework for prompt corrective
action. To be categorized as well capitalized the Bank must maintain minimum
amounts and ratios, as set forth in the table below. There are no conditions or
events since that notification that management believes have changed the Bank's
category. The Bank's actual regulatory capital amounts and ratios as of December
31, 2009 and 2008 are presented in the table below (dollars in
thousands):
 
 Actual
                  
                  
                  Minimum
      for Capital
                    Adequacy Purposes
                  
                  
                  Minimum
      to be Well
                    Capitalized
      under
                    Prompt
      Corrective
                    Action ProvisionsAmount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  RatioDecember
      31, 2009:Total
      Capital (to Risk Weighted Assets)
                  
                  $
                  88,282
                  
                  
                  
                  13.5
                  %
                  
                  $
                  52,250
                  
                  
                  
                  8.0
                  %
                  
                  $
                  65,312
                  
                  
                  
                  10.0
                  %Tier
      1 Capital (to Risk Weighted Assets)
                  
                  
                  80,049
                  
                  
                  
                  12.3
                  %
                  
                  
                  26,125
                  
                  
                  
                  4.0
                  %
                  
                  
                  39,187
                  
                  
                  
                  6.0
                  %Tier
      1 Capital (to Average Assets)
                  
                  
                  80,049
                  
                  
                  
                  9.6
                  %
                  
                  
                  33,506
                  
                  
                  
                  4.0
                  %
                  
                  
                  41,883
                  
                  
                  
                  5.0
                  %December
      31, 2008:Total
      Capital (to Risk Weighted Assets)
                  
                  $
                  90,054
                  
                  
                  
                  12.4
                  %
                  
                  $
                  58,268
                  
                  
                  
                  8.0
                  %
                  
                  $
                  72,835
                  
                  
                  
                  10.0
                  %Tier
      1 Capital (to Risk Weighted Assets)
                  
                  
                  80,914
                  
                  
                  
                  11.1
                  %
                  
                  
                  29,134
                  
                  
                  
                  4.0
                  %
                  
                  
                  43,701
                  
                  
                  
                  6.0
                  %Tier
      1 Capital (to Average Assets)
                  
                  
                  80,914
                  
                  
                  
                  9.2
                  %
                  
                  
                  35,195
                  
                  
                  
                  4.0
                  %
                  
                  
                  43,994
                  
                  
                  
                  5.0
                  %
  12.
EARNINGS PER SHARE
 
 The
following table provides a reconciliation of income available to common
stockholders and the average number of shares outstanding (less unearned
deferred stock awards and treasury shares) for the years ended December 31,
2009, 2008 and 2007. Options to purchase 171,770, 172,295 and 255,919 shares of
common stock were outstanding at December 31, 2009, 2008, and 2007,
respectively.
 
 Years Ended December 31,2009
                      
                      
                      2008
                      
                      
                      2007Net
      income (numerator)
                      
                      $
                      7,035,836
                      
                      
                      $
                      10,987,820
                      
                      
                      $
                      17,003,227Weighted
      average shares outstandingfor
      basic EPS (denominator)
                      
                      
                      9,738,225
                      
                      
                      
                      9,761,944
                      
                      
                      
                      9,914,929Dilutive
      effect of stock options
                      
                      
                      19
                      
                      
                      
                      19,817
                      
                      
                      
                      112,799Adjusted
      shares for diluted EPS
                      
                      
                      9,738,244
                      
                      
                      
                      9,781,761
                      
                      
                      
                      10,027,728
 
 For the
years ended December 31, 2009 and 2008, there were 120,687 and 132,012 options,
respectively, that were antidilutive since the exercise price exceeded the
average market price of the Company’s common stock for the years. These options
have been omitted from the calculation of diluted earnings per share for 2009
and 2008.
  33
 
 13.
MORTGAGE BANKING ACTIVITIES
 
 Mortgage
loans serviced for others are not included in the accompanying consolidated
statements of financial condition. The unpaid principal balances of mortgage
loans serviced for others were $289,323,578, $255,509,602 and $254,670,534 at
December 31, 2009, 2008, and 2007, respectively. Servicing loans for others
generally consists of collecting mortgage payments, maintaining escrow accounts,
disbursing payment to investors and foreclosure processing. Loan servicing
income is recorded on the accrual basis and includes servicing fees from
investors and certain charges collected from borrowers, such as late payment
fees.
 
 At
December 31, 2009 and 2008, mortgage servicing rights reported in the
consolidated statements of financial condition, net of amortization, were
$1,278,688 and $1,005,725, respectively.
 
 During
the years ended December 31, 2009 and 2008, respectively, the Company recorded
additional servicing assets of $730,125 and $257,930 as a result of sales of
loans or mortgage-backed securities. Amortization of servicing assets during the
years ended December 31, 2009, 2008, and 2007 aggregated $457,162, $402,820, and
$363,068, respectively. The fair value of recognized servicing assets amounted
to approximately $2,457,000 and $2,823,000 as of December 31, 2009 and 2008,
respectively. The Company's significant assumptions used to estimate their fair
value include weighted average life, prepayment speeds, and expected costs to
transfer servicing to a third party.
 
 14.
FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT
GROUP
 CONCENTRATION
OF CREDIT RISK
 
 The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers and to
reduce its own exposure to fluctuations in interest rates. These financial
instruments include commitments to extend credit and involve, to varying
degrees, elements of credit and interest rate risk in excess of the amount
recognized in the consolidated statements of financial condition.
 
 The
Company's exposure to credit loss in the event of non-performance by the other
party to the financial instruments for commitments to extend credit 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.
 
 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. The Company evaluates each customer's creditworthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the Company upon extension of credit, is based on management's credit evaluation
of the borrower.
 
 The
Company's lending is concentrated primarily in central, eastern, northeastern
and southeastern North Carolina. Credit has been extended to certain of the
Company's customers through multiple lending transactions. Since many of the
commitments are expected to expire without being drawn upon, amounts reported do
not necessarily represent future cash requirements.  A summary of the
contractual amounts of the Company's exposure to off-balance sheet risk as of
December 31, 2009 and 2008 are as follows:
 
 December 31,2009
                        
                        
                        2008Commitments
      to extend credit
                        
                        $
                        47,338,000
                        
                        
                        $
                        66,428,000Undrawn
      balances on lines of credit and undrawnbalances
      on credit reserves (overdraft protection)
                        
                        
                        49,756,000
                        
                        
                        
                        51,504,000Standby
      letters of credit
                        
                        
                        1,007,000
                        
                        
                        
                        2,384,000Total
                        
                        $
                        98,101,000
                        
                        
                        $
                        120,316,000
 
 Included
in the commitments to originate loans as of December 31, 2009 and December 31,
2008, are fixed interest rate loan commitments of approximately $12.2 million
and $14.5 million, respectively. The shorter duration of interest-sensitive
liabilities, to the extent they are used to fund these fixed-rate loans,
indicates that the Company is exposed to interest rate risk because, in a rising
rate environment, liabilities will be repricing faster at higher interest rates,
thereby reducing the market value of fixed-rate long-term assets and net
interest income.
  34
 
 15.
PARENT COMPANY FINANCIAL INFORMATION
 
 The
Company's principal asset is its investment in the Bank. Condensed financial
statements of the parent company as of December 31, 2009, 2008 and 2007 are as
follows:
 
 Years Ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007CONDENSED
      BALANCE SHEETSCash
                  
                  $
                  1,994,259
                  
                  
                  $
                  2,003,541
                  
                  
                  $
                  1,961,421Investment
      in wholly-owned subsidiary
                  
                  
                  84,821,988
                  
                  
                  
                  86,637,727
                  
                  
                  
                  85,509,789Other
      assets
                  
                  
                  11,656,316
                  
                  
                  
                  11,437,376
                  
                  
                  
                  10,737,756Total
      assets
                  
                  $
                  98,472,563
                  
                  
                  $
                  100,078,644
                  
                  
                  $
                  98,208,966Junior
      subordinated debentures
                  
                  $
                  10,310,000
                  
                  
                  $
                  10,310,000
                  
                  
                  $
                  10,310,000Other
      liabilities
                  
                  
                  1,948,459
                  
                  
                  
                  1,947,619
                  
                  
                  
                  1,863,644Stockholders'
      equity
                  
                  
                  86,214,104
                  
                  
                  
                  87,821,025
                  
                  
                  
                  86,035,322Total
      liabilities and stockholders' equity
                  
                  $
                  98,472,563
                  
                  
                  $
                  100,078,644
                  
                  
                  $
                  98,208,966CONDENSED
      STATEMENTS OF INCOMEInterest
      on junior subordinated debentures
                  
                  $
                  389,677
                  
                  
                  $
                  657,576
                  
                  
                  $
                  839,110Equity
      in earnings of subsidiary
                  
                  
                  7,322,965
                  
                  
                  
                  11,481,054
                  
                  
                  
                  17,660,805Miscellaneous
      income (loss)
                  
                  
                  (676,806
                  )
                  
                  
                  164,342
                  
                  
                  
                  181,532Net
      income
                  
                  $
                  7,035,836
                  
                  
                  $
                  10,987,820
                  
                  
                  $
                  17,003,227CONDENSED
      STATEMENTS OF CASH FLOWSOperating
      activities:Net
      income
                  
                  $
                  7,035,836
                  
                  
                  $
                  10,987,820
                  
                  
                  $
                  17,003,227Adjustments
      to reconcile net income to net cash used in operating
      activities:Amortization
      of intangibles
                  
                  
                  
                  
                  
                  
                  18,767
                  
                  
                  
                  24,996Equity
      in undistributed earnings of subsidiary
                  
                  
                  (7,322,965
                  )
                  
                  
                  (11,481,054
                  )
                  
                  
                  (17,660,805
                  )Other
      operating activities
                  
                  
                  (218,940
                  )
                  
                  
                  (718,390
                  )
                  
                  
                  (2,674,648
                  )Net
      cash used in operating activities
                  
                  
                  (506,069
                  )
                  
                  
                  (1,192,857
                  )
                  
                  
                  (8,775,498
                  )Investing
      activities:Payments
      for investments in and advances to subsidiary
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Repayments
      of advances to subsidiary
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Upstream
      dividend received from First South Bank
                  
                  
                  8,281,493
                  
                  
                  
                  11,156,103
                  
                  
                  
                  14,200,140Net
      cash provided by investing activities
                  
                  
                  8,281,493
                  
                  
                  
                  11,156,103
                  
                  
                  
                  14,200,140Financing
      activities:Proceeds
      from exercise of stock options
                  
                  
                  6,271
                  
                  
                  
                  640,063
                  
                  
                  
                  3,459,780Purchase
      of treasury shares
                  
                  
                  -
                  
                  
                  
                  (2,845,412
                  )
                  
                  
                  (6,722,276
                  )Cash
      paid for dividends
                  
                  
                  (7,790,977
                  )
                  
                  
                  (7,715,777
                  )
                  
                  
                  (7,342,722
                  )Net
      cash used in financing activities
                  
                  
                  (7,784,706
                  )
                  
                  
                  (9,921,126
                  )
                  
                  
                  (10,605,218
                  )Net
      increase (decrease) in cash
                  
                  
                  (9,282
                  )
                  
                  
                  42,120
                  
                  
                  
                  287,692Cash
      at beginning of year
                  
                  
                  2,003,541
                  
                  
                  
                  1,961,421
                  
                  
                  
                  1,673,729Cash
      at end of year
                  
                  $
                  1,994,259
                  
                  
                  $
                  2,003,541
                  
                  
                  $
                  1,961,421
  35
 
 16.
QUARTERLY FINANCIAL DATA (UNAUDITED)
 
 Summarized
unaudited quarterly financial data for the years ended December 31, 2009 and
2008 is as follows (dollars in thousands):
  Fourth
                    
                    
                    Third
                    
                    
                    Second
                    
                    
                    First2009:Interest
      income
                    
                    $
                    11,851
                    
                    
                    $
                    12,196
                    
                    
                    $
                    12,442
                    
                    
                    $
                    12,571Interest
      expense
                    
                    
                    2,997
                    
                    
                    
                    3,922
                    
                    
                    
                    4,546
                    
                    
                    
                    4,629Provision
      for credit losses
                    
                    
                    2,700
                    
                    
                    
                    1,260
                    
                    
                    
                    1,700
                    
                    
                    
                    1,520Noninterest
      income
                    
                    
                    2,525
                    
                    
                    
                    2,401
                    
                    
                    
                    3,213
                    
                    
                    
                    2,821Noninterest
      expense
                    
                    
                    6,299
                    
                    
                    
                    6,530
                    
                    
                    
                    6,514
                    
                    
                    
                    6,002Income
      tax expense
                    
                    
                    871
                    
                    
                    
                    1,123
                    
                    
                    
                    1,135
                    
                    
                    
                    1,236Net
      income
                    
                    $
                    1,509
                    
                    
                    $
                    1,762
                    
                    
                    $
                    1,760
                    
                    
                    $
                    2,005Net
      income per common shareBasic
                    
                    $
                    .15
                    
                    
                    $
                    .18
                    
                    
                    $
                    .18
                    
                    
                    $
                    .21Diluted
                    
                    $
                    .15
                    
                    
                    $
                    .18
                    
                    
                    $
                    .18
                    
                    
                    $
                    .21Fourth
                    
                    
                    Third
                    
                    
                    Second
                    
                    
                    First2008:Interest
      income
                    
                    $
                    13,372
                    
                    
                    $
                    14,389
                    
                    
                    $
                    15,219
                    
                    
                    $
                    16,383Interest
      expense
                    
                    
                    5,078
                    
                    
                    
                    5,411
                    
                    
                    
                    6,045
                    
                    
                    
                    6,783Provision
      for credit losses
                    
                    
                    1,150
                    
                    
                    
                    1,745
                    
                    
                    
                    1,149
                    
                    
                    
                    -Noninterest
      income
                    
                    
                    2,149
                    
                    
                    
                    2,441
                    
                    
                    
                    2,821
                    
                    
                    
                    2,674Noninterest
      expense
                    
                    
                    5,987
                    
                    
                    
                    6,322
                    
                    
                    
                    5,896
                    
                    
                    
                    5,960Income
      tax expense
                    
                    
                    1,287
                    
                    
                    
                    1,296
                    
                    
                    
                    1,938
                    
                    
                    
                    2,413Net
      income
                    
                    $
                    2,019
                    
                    
                    $
                    2,056
                    
                    
                    $
                    3,012
                    
                    
                    $
                    3,901Net
      income per common shareBasic
                    
                    $
                    .21
                    
                    
                    $
                    .21
                    
                    
                    $
                    .31
                    
                    
                    $
                    .40Diluted
                    
                    $
                    .21
                    
                    
                    $
                    .20
                    
                    
                    $
                    .31
                    
                    
                    $
                    .40
 
 17.
FAIR VALUES OF FINANCIAL INSTRUMENTS
 
 Financial
accounting standards require the disclosure of estimated fair values for
financial instruments. Quoted market prices, if available, are utilized as an
estimate of the fair value of financial instruments. Because no quoted market
prices exist for a significant part of the Company's financial instruments, the
fair value of such instruments has been derived based on management's
assumptions with respect to future economic conditions, the amount and timing of
future cash flows and estimated discount rates with respect to future economic
conditions, the amount and timing of future cash flows and estimated discount
rates. Different assumptions could significantly affect these estimates.
Accordingly, the net realizable value could be materially different from the
estimates presented below. In addition, the estimates are only indicative of
individual financial instruments' values and should not be considered an
indication of the fair value of the Company taken as a whole.
 
 Fair
values have been estimated using data which management considers as the best
available, and estimation methodologies deemed suitable for the pertinent
category of financial instrument.  The estimation methodologies,
resulting fair values, and recorded carrying amounts at December 31, 2009 and
2008 were as follows:
 
 Cash and
cash equivalents are by definition short-term and do not present any
unanticipated credit issues. Therefore, the carrying amount is a reasonable
estimate of fair value. The estimated fair values of investment securities and
mortgage-backed securities are provided in Notes 2 and 3 to the financial
statements. These are based on quoted market prices, when available. If a quoted
market price is not available, fair value is estimated using quoted market
prices for similar securities.
 
 The fair
value of the net loan portfolio has been estimated using the present value of
expected cash flows, discounted at an interest rate adjusted for servicing costs
and giving consideration to estimated prepayment risk and credit loss factors,
as follows:
  36
 
 17.
FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)
 
 December 31, 2009
                  
                  
                  December 31, 2008Estimated
                    fair value
                  
                  
                  Carrying amount
                  
                  
                  Estimated
                    fair value
                  
                  
                  Carrying
                    amount1 -
      4 family mortgages
                  
                  $
                  52,859,820
                  
                  
                  $
                  51,820,569
                  
                  
                  $
                  47,316,937
                  
                  
                  $
                  46,128,989Consumer
                  
                  
                  89,057,502
                  
                  
                  
                  88,892,520
                  
                  
                  
                  102,289,498
                  
                  
                  
                  101,303,120Non-residential
                  
                  
                  517,942,429
                  
                  
                  
                  517,942,429
                  
                  
                  
                  597,299,188
                  
                  
                  
                  597,299,188Total
                  
                  $
                  659,859,751
                  
                  
                  $
                  658,655,518
                  
                  
                  $
                  746,905,623
                  
                  
                  $
                  744,731,297
 
 The fair
value of deposit liabilities with no stated maturities has been estimated to
equal the carrying amount (the amount payable on demand), totaling $247,644,753
and $249,921,423 at December 31, 2009 and 2008, respectively. The fair value
estimates for these products do not reflect the benefits that the Bank receives
from the low-cost, long-term funding they provide. These benefits are considered
significant.
 
 The fair
value of certificates of deposit and advances from the FHLB is estimated by
discounting the future cash flows using the current rates offered for similar
deposits and advances with the same remaining maturities. The carrying value and
estimated fair values of certificates of deposit and FHLB advances at December
31, 2009 and 2008 are as follows:
 
 2009
                  
                  
                  2008Certificates
      of deposit:Carrying
      amount
                  
                  $
                  440,866,305
                  
                  
                  $
                  466,505,373Estimated
      fair value
                  
                  
                  444,572,051
                  
                  
                  
                  473,896,700Advances
      for Federal Home Loan Bank:Carrying
      amount
                  
                  $
                  35,000,000
                  
                  
                  $
                  45,000,000Estimated
      fair value
                  
                  
                  35,550,962
                  
                  
                  
                  45,496,419
 
 The
carrying amount of accrued interest receivable, FHLB stock, notes receivable,
junior subordinated debentures, accrued interest payable, and repurchase
agreements approximates their fair value.
 
 There is
no material difference between the carrying amount and estimated fair value of
off-balance sheet items totaling $98,101,000 and $120,316,000 at December 31,
2009 and 2008, respectively, which are primarily comprised of unfunded loan
commitments.
 
 18. FAIR VALUE HIERACHY
 
 A fair
value hierarchy prioritizes the inputs of valuation techniques used to measure
fair value of nonfinancial assets and liabilities. The inputs are evaluated and
an overall level for the fair value measurement is determined. This overall
level is an indication of the market observability of the fair value
measurement. Financial accounting standards clarify fair value in terms of the
price in an orderly transaction between market participants to sell an asset or
transfer a liability in the principal (or most advantageous) market for the
asset or liability at the measurement date (an exit price). In order to
determine the fair value or the exit price, the Bank must determine the unit of
account, highest and best use, principal market, and market
participants.  These determinations allow the Bank to define the
inputs for fair value and level of hierarchy.
 
 Outlined
below is the application of the fair value hierarchy to the Bank’s financial
assets that are carried at fair value.
 
 Level
1-inputs to the valuation methodology are quoted prices (unadjusted) in active
markets for identical assets or liabilities that the reporting entity has the
ability to access at the measurement date. A quoted price in an active market
provides the most reliable evidence of fair value and shall be used to measure
fair value whenever available. The type of assets carried at Level 1 fair value
generally includes investments such as U. S. Treasury and U. S. government
agency securities.
 
 Level
2-inputs to the valuation methodology include quoted prices for similar assets
or liabilities in active markets and price quotations can vary substantially
either over time or among market makers. The type of assets carried at Level 2
fair value generally includes investment securities such as Government Sponsored
Enterprises (“GSEs”) and the Bank’s investment in other real estate
owned.
  37
 
 18.
FAIR VALUE HIERACHY (Continued)
 
 Level
3-inputs to the valuation methodology are unobservable to the extent that
observable inputs are not available.  Unobservable inputs are
developed based on the best information available in the circumstances and might
include the Bank’s own assumptions.  The Bank shall not ignore
information about market participant assumptions that is reasonably available
without undue cost and effort. The type of assets carried at Level 3 fair value
generally include investments backed by non-traditional mortgage loans or
certain state or local housing agency obligations,  of which the Bank
has no such assets or liabilities.
 
 Assets
measured at fair value on a recurring basis at December 31, 2009 and 2008 were
as follows:
 
 Quoted Prices
                      in Active
                      Markets for
                      Identical Assets
                    
                    
                    Significant
                      Other
                      Observable
                      Inputs
                    
                    
                    Significant
                      Unobservable
                      InputsDescription
                    
                    12-31-09
                    
                    
                    (Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)Available
      for sale securities:Investment
                    
                    $
                    407,317
                    
                    
                    $
                    407,317
                    
                    
                    $
                    -
                    
                    
                    $
                    -Mortgage-backed
                    
                    
                    96,725,468
                    
                    
                    
                    -
                    
                    
                    
                    96,725,468
                    
                    
                    
                    -Other
      real estate owned
                    
                    
                    10,561,071
                    
                    
                    
                    -
                    
                    
                    
                    10,561,071
                    
                    
                    
                    -Total
      December 31, 2009
                    
                    $
                    107,693,856
                    
                    
                    $
                    407,317
                    
                    
                    $
                    107,286,539
                    
                    
                    $
                    -
 
 Quoted Prices
                      in Active
                      Markets for
                      IdenticalAssets
                    
                    
                    Significant
                      Other
                      Observable
                      Inputs
                    
                    
                    Significant
                      Unobservable
                      InputsDescription
                    
                    12-31-08
                    
                    
                    (Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)Available
      for sale securities:Investment
                    
                    $
                    36,563,646
                    
                    
                    $
                    343,642
                    
                    
                    $
                    36,220,004
                    
                    
                    $
                    -Mortgage-backed
                    
                    
                    31,995,157
                    
                    
                    
                    -
                    
                    
                    
                    31,995,157
                    
                    
                    
                    -Other
      real estate owned
                    
                    
                    7,710,560
                    
                    
                    
                    -
                    
                    
                    
                    7,710,560
                    
                    
                    
                    -Total
      December 31, 2008
                    
                    $
                    76,269,363
                    
                    
                    $
                    343,642
                    
                    
                    $
                    75,925,721
                    
                    
                    $
                    -
 
 Assets
measured at fair value on a non-recurring basis at December 31, 2009 and 2008
were as follows:
 
 Quoted Prices
                      in Active
                      Markets for
                      Identical Assets
                    
                    
                    Significant
                      Other
                      Observable
                      Inputs
                    
                    
                    Significant
                      Unobservable
                      InputsDescription
                    
                    12-31-09
                    
                    
                    (Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)Impaired
      loans, net of specific allowance
                    
                    $
                    17,850,368
                    
                    
                    $
                    -
                    
                    
                    $
                    17,850,368
                    
                    
                    $
                    -Total
      December 31, 2009
                    
                    $
                    17,850,368
                    
                    
                    $
                    -
                    
                    
                    $
                    17,850,368
                    
                    
                    $
                    -
 
 Quoted Prices
                      in Active
                      Markets for
                      Identical Assets
                    
                    
                    Significant
                      Other
                      Observable
                      Inputs
                    
                    
                    Significant
      Unobservable
                      InputsDescription
                    
                    12-31-08
                    
                    
                    (Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)Impaired
      loans, net of specific allowance
                    
                    $
                    6,595,975
                    
                    
                    $
                    -
                    
                    
                    $
                    6,595,975
                    
                    
                    $
                    -Total
      December 31, 2008
                    
                    $
                    6,595,975
                    
                    
                    $
                    -
                    
                    
                    $
                    6,595,975
                    
                    
                    $
                    -
 
 Quoted
market price for similar assets in active markets is the valuation technique for
determining fair value of available for sale securities. Unrealized gains on
available for sale securities are included in the “accumulated other
comprehensive income” component of the Stockholders’ Equity section of the
Consolidated Statements of Financial Condition.
  38
  18.
FAIR VALUE HIERACHY (Continued)
 
 The
Company does not record loans at fair value on a recurring basis. However, when
a loan is considered impaired, and an allowance for loan losses is established
based on the estimated fair value of the loan. The fair value of impaired loans
is estimated using one of several methods, including collateral value, market
value of similar debt, enterprise value, liquidation value and discounted cash
flows. Those impaired loans not requiring an allowance represent loans for which
the fair value of the expected repayments or collateral exceed the recorded
investments in such loans. Impaired loans where a specific allowance is
established based on the fair value of collateral require classification in the
fair value hierarchy. When the fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
impaired loan as nonrecurring Level 2. When an appraised value is not available
or management determines the fair value of the collateral is further impaired
below the appraised value and there is no observable market price, the Company
classifies the impaired loan as nonrecurring Level 3.
 
 Other
real estate owned acquired through loan foreclosure is recorded at fair value
upon transfer of the loans to foreclosed assets, based on the appraised market
value of the property. Subsequently, foreclosed assets are carried at the lower
of carrying value or fair value. Fair value is based upon independent market
prices, appraised values of the collateral or management’s estimation of the
value of the collateral. When the fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
foreclosed asset as nonrecurring Level 2. When an appraised value is not
available or management determines the fair value of the collateral is further
impaired below the appraised value and there is no observable market price, the
Company classifies the foreclosed asset as nonrecurring Level 3. Fair value
adjustments of $2.2 million and $772,000 were made to other real estate owned
during the years ended December 31, 2009 and 2008, respectively.  Loss
on sale of other real estate owned realized and included in earnings for years
ending December 31, 2009 and 2008 was $200,732 and $80,542,
respectively.
 
 No
liabilities were measured at fair value on a recurring basis during the year
ended December 31, 2009 and 2008.
 
 19.
SUPPLEMENTAL CASH FLOW INFORMATION
 
 Supplemental
cash flow information for the years ended December 31, 2009, 2008 and 2007 is as
follows:
 
 Year ended December 31,2009
                  
                  
                  2008
                  
                  
                  2007Real
      estate acquired in settlement of loans
                  
                  $
                  15,838,273
                  
                  
                  $
                  10,882,390
                  
                  
                  $
                  1,594,724Exchange
      of loans for mortgage-backed securities
                  
                  
                  75,485,932
                  
                  
                  
                  3,399,071
                  
                  
                  
                  6,873,490Cash
      paid for interest
                  
                  
                  16,135,628
                  
                  
                  
                  23,358,551
                  
                  
                  
                  29,053,118Cash paid for income taxes
                  
                  
                  5,712,432
                  
                  
                  
                  7,567,051
                  
                  
                  
                  8,705,060Dividends
      declared, not paid
                  
                  
                  1,948,459
                  
                  
                  
                  1,947,619
                  
                  
                  
                  1,863,644
 
 20.
JUNIOR SUBORDINATED DEBENTURES
 
 The
Company has sponsored a trust, First South Preferred Trust I (the Trust), of
which 100% of the common equity is owned by the Company. The Trust was formed
for the purpose of issuing company-obligated preferred trust securities (the
Preferred Trust Securities) to third-party investors and investing the proceeds
from the sale of such Preferred Trust Securities solely in junior subordinated
debt securities of the Company (the Debentures). The Debentures held by the
Trust are the sole assets of the Trust. Distributions on the Preferred Trust
Securities issued by the Trust are payable quarterly at a rate equal to the
interest rate being earned by the Trust on the Debentures held by that Trust.
The Preferred Trust Securities are subject to mandatory redemption, in whole or
in part, upon repayment of the Debentures. The Company has entered into an
agreement, which fully and unconditionally guarantees the Preferred Trust
Securities subject to the terms of the guarantee. The Debentures held by the
Trust are first redeemable, in whole or in part, by the Company on or after
September 30, 2008.
 
 In the
fourth quarter of 2003, as a result of applying the provisions of GAAP,
governing when an equity interest should be consolidated, the Company was
required to deconsolidate the subsidiary Trust from its financial statements.
The deconsolidation of the net assets and results of operations of the Trust had
virtually no impact on the Company's financial statements or liquidity position
since the Company continues to be obligated to repay the Debentures held by the
Trust and guarantees repayment of the Preferred Trust Securities issued by the
Trust. The consolidated debt obligation related to the Trust increased from $10
million to $10.3 million upon deconsolidation with the difference representing
the Company's common ownership interest in the Trust. Subject to certain
limitations, the Junior Subordinated Debentures qualify as Tier 1 capital for
the Company under Federal Reserve Board guidelines.
  39
 
 20.
JUNIOR SUBORDINATED DEBENTURES (Continued)
 
 Consolidated
debt obligations as of December 31, 2009 related to a subsidiary Trust holding
solely Debentures of the Company follows:
 
 LIBOR
      + 2.95% junior subordinated debentures owed to First South Preferred Trust
      I due September 26, 2033
                  
                  $
                  10,000,000LIBOR
      + 2.95% junior subordinated debentures owed to First South Preferred Trust
      I due September 26, 2033
                  
                  
                  310,000Total
      junior subordinated debentures owed to unconsolidated subsidiary
      trust
                  
                  $
                  10,310,000
 
 21.
RELATED PARTY TRANSACTIONS
 
 The
Company had loans outstanding to executive officers, directors and their
affiliated companies. Management believes that these loans are made and
processed on the same basis as loans to non-related parties. An analysis of the
activity with respect to such aggregate extensions of credit to related parties
is as follows:
 
 Extensions
      of credit at December 31, 2008
                  
                  $
                  1,398,782New
      extensions of credit made during the year
                  
                  
                  -Repayments
      during the year
                  
                  
                  (320,933
                  )Extensions
      of credit at December 31, 2009
                  
                  $
                  1,077,849
 
 22.
SUBSEQUENT EVENTS
 
 The
Company has evaluated all subsequent events through March 8, 2010, the date the
consolidated statements of financial condition of the Company as of December 31,
2009 and the related consolidated statements of operations, changes in
stockholders' equity, and cash flows for each of the year then ended were
available to be issued. No events have occurred subsequent to December 31, 2009
and through March 8, 2010 that would require adjustment to or disclosure in the
financial information referred to in these financial
statements.
  40





BOARD
      OF DIRECTORSFrederick
      N. Holscher
                
                Marshall
      T. Singleton
                
                Linley
      H. Gibbs, Jr.
                
                Frederick
      H. HowdyChairman
                
                Vice
      Chairman
                
                Retired
                
                PresidentPartner

                    Rodman,
      Holscher,
                
                Co-Owner

                    B.
      E. Singleton & Sons
                
                Washington,
      NC
                
                Drs.
      Freshwater & Howdy,
                  P.A.Francisco,
      & Peck, P.A.
                
                Washington,
      NC
                
                
                
                Washington,
      NCWashington,
      NCCharles
      E. Parker, Jr.
                
                H.
      D. Reaves, Jr.
                
                Thomas
      A. VannSenior
      Vice President
                
                Former
      President and
                
                President
      andRobinson
      & Stith Insurance
                
                Chief
      Executive Officer
                
                Chief
      Executive OfficerNew
      Bern, NC
                
                Home
      Federal Savings & Loan
                
                First
      South BankFayetteville,
      NC
                
                Washington,
      NCEXECUTIVE
      OFFICERSThomas
      A. Vann
                
                J.
      Randy Woodson
                
                William
      L. Wall
                
                John
      F. Nicholson, Jr.President
      and
                
                Executive
      Vice President
                
                Executive
      Vice President
                
                Executive
      Vice PresidentChief
      Executive Officer
                
                Chief
      Operating Officer
                
                Chief
      Financial Officer and
                
                Chief
      Credit OfficerSecretaryPaul
      S. Jaber
                
                Sherry
      L. Correll
                
                Mary
      R. Boyd
                
                Kristie
      W. HawkinsExecutive
      Vice President
                
                Executive
      Vice President
                
                Executive
      Vice President
                
                Treasurer
      andMortgage
      Lending
                
                Bank
      Operations
                
                Loan
      Servicing
                
                ControllerAREA
      EXECUTIVESOtto
      C. Burrell, Jr.
                
                Robert
      M. Hertenstein
                
                Kenneth
      K. Howard, Jr.
                
                Dennis
      A. NicholsSenior
      Vice President
                
                Senior
      Vice President
                
                Senior
      Vice President
                
                Senior
      Vice PresidentArea
      Executive
                
                Area
      Executive
                
                Area
      Executive
                
                Area
      ExecutiveCoastal
      Region
                
                Cape
      Fear Region
                
                Tar
      Region
                
                Neuse/Pamlico
      RegionCITY
      AND SUBSIDIARY EXECUTIVESEric
      S. Clark
                
                Jerry
      G. Hannah
                
                Joseph
      M. Johnson
                
                Thomas
      S. LewisVice
      President
                
                Vice
      President
                
                Senior
      Vice President
                
                Vice
      PresidentCity
      Executive
                
                City
      Executive
                
                City
      Executive
                
                City
      ExecutiveGreenville,
      NC
                
                Kinston,
      NC
                
                Durham,
      NC
                
                Rocky
      Mount, NCKenneth
      W. Marshall, Jr.
                
                Rhonda
      B. McLeod
                
                Robert
      C. Pfeiffer
                
                William
      P. StoneVice
      President
                
                Vice
      President
                
                Senior
      Vice President
                
                Vice
      PresidentCity
      Executive
                
                City
      Executive
                
                City
      Executive
                
                City
      ExecutiveOuter
      Banks, NC
                
                Hope
      Mills, NC
                
                Elizabeth
      City, NC
                
                Lumberton,
      NCMichael
      M. Wooles
                
                Donnie
      L. G. BunnSenior
      Vice President
                
                PresidentCity
      Executive
                
                First
      South Leasing, LLCWashington,
      NC
                
                Greenville,
      NC


41





FIRST
SOUTH BANK OFFICE LOCATIONS





Buxton
            
            Hope
      Mills
            
            Raleigh47560
      NC Highway 12
            
            3103
      North Main Street
            
            4800
      Six Forks RoadBuxton,
      NC 27920
            
            Hope
      Mills, NC 28348
            
            Suite
      115(252)
      995-3250
            
            (910)
      423-0952
            
            Raleigh,
      NC 27609(919)
      783-5222Chocowinity
            
            Kinston2999
      Highway 17 South
            
            2430
      Herritage Street
            
            TarboroChocowinity,
      NC 27817
            
            Kinston,
      NC 28504
            
            100
      East Hope Lodge Street(252)
      940-4970
            
            (252)
      523-9449
            
            Tarboro,
      NC 27886(252)
      823-0157Dunn
            
            Lumberton904-A
      West Broad Street
            
            600
      North Chestnut Street
            
            WashingtonDunn,
      NC 28334
            
            Lumberton,
      NC 28358
            
            1311
      Carolina Avenue(910)
      892-2861
            
            (910)
      739-3274
            
            Washington,
      NC 27889(252)
      946-4178Durham
            
            3000
      North Elm Street4215-01
      University Drive
            
            Lumberton,
      NC 28359
            
            300
      North Market StreetDurham,
      NC 27707
            
            (910)
      608-5031
            
            Washington,
      NC 27889(919)
      403-1000
            
            
            
            (252)
      940-4945Nags
      HeadElizabeth
      City
            
            2236
      South Croatan Highway
            
            1328
      John Small Avenue604
      East Ehringhaus Street
            
            Suite
      6
            
            Washington,
      NC 27889Elizabeth
      City, NC 27909
            
            Nags
      Head, NC 27959
            
            (252)
      940-5000(252)
      335-0848
            
            (252)
      441-9935WilmingtonFayetteville
            
            New
      Bern
            
            2601
      Irongate Drive241
      Green Street
            
            202
      Craven Street
            
            Suite
      102Fayetteville,
      NC 28301
            
            New
      Bern, NC 28560
            
            Wilmington,
      NC 28412(910)
      483-3681
            
            (252)
      636-2997
            
            (910)-798-6102705
      Executive Place
            
            1725
      Glenburnie RoadFayetteville,
      NC 28305
            
            New
      Bern, NC 28562
            
            Loan
      Production Office(910)
      484-2116
            
            (252)
      636-3569
            
            3210
      North Croatan HighwayKill
      Devil Hills, NC 27948Grantsboro
            
            Rocky
      Mount
            
            (252)
      441-983411560
      NC Highway 55
            
            300
      Sunset AvenueSuite
      11
            
            Rocky
      Mount, NC 27804Grantsboro,
      NC 28529
            
            (252)
      972-9661
            
            First
      South Leasing(252)
      745-5001
            
            
            
            1035
      Director Court, Unit C2901
      Sunset Avenue
            
            Greenville,
      NC 27858Greenville
            
            Rocky
      Mount, NC 27804
            
            (252)
    355-4536301
      East Arlington Blvd
            
            (252)
      451-1259Greenville,
      NC 27858(252)
      321-2600
            
            1378
      Benvenue Road
            
            Operations
      Center andRocky
      Mount, NC 27804
            
            Credit
      Administration907
      East Firetower Road
            
            (252)
      442-8375
            
            220
      Creekside DriveGreenville,
      NC 27835
            
            
            
            Washington,
      NC 27889(252)
      355-4644
            
            3635
      North Halifax Road
            
            (252)
      946-4178Rocky
      Mount, NC 278041707
      SE Greenville Blvd
            
            (252)
      451-8700Greenville,
      NC 27858(252)752-2770





Member
      FDIC


42


STOCKHOLDER
INFORMATION





Corporate
      HeadquartersFirst
      South Bancorp, Inc.
              Telephone:  252-946-41781311
      Carolina Avenue
              Fax:  252-946-3873Washington,
      NC  27889
              E-mail:  info@firstsouthnc.comWebsite:  www.firstsouthnc.com





Stock
Listing Information


The
Company's common stock is listed and trades on the NASDAQ Global Select Market
under the symbol FSBK. There were 779 registered stockholders of record as of
March 8, 2010.




Stock
Price Information


The
following table presents the high and low trading price information and
dividends declared per share for the periods indicated.





Quarter Ended
                  
                  High
                  
                  
                  Low
                  
                  
                  DividendsMarch
      31, 2009
                  
                  $
                  13.58
                  
                  
                  $
                  5.80
                  
                  
                  $
                  .20June
      30, 2009
                  
                  
                  12.69
                  
                  
                  
                  9.00
                  
                  
                  
                  .20September
      30, 2009
                  
                  
                  13.90
                  
                  
                  
                  11.00
                  
                  
                  
                  .20December
      31, 2009
                  
                  
                  11.95
                  
                  
                  
                  9.88
                  
                  
                  
                  .20March
      31, 2008
                  
                  $
                  23.49
                  
                  
                  $
                  18.17
                  
                  
                  $
                  .20June
      30, 2008
                  
                  
                  23.48
                  
                  
                  
                  12.88
                  
                  
                  
                  .20September
      30, 2008
                  
                  
                  20.00
                  
                  
                  
                  12.77
                  
                  
                  
                  .20December
      31, 2008
                  
                  
                  17.50
                  
                  
                  
                  9.50
                  
                  
                  
                  .20





Registrar
and Transfer Agent


Inquiries
regarding stock transfer, registration, lost certificates or changes in name and
address should be directed to the Company’s stock registrar and transfer agent:
Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016;
via the Internet at www.rtco.com; or toll-free at
800-866-1340.





Form
10-K


The
Annual Report on Form 10-K of the Company as filed with the Securities and
Exchange Commission is available via the Internet on the Company’s website at
www.firstsouthnc.comunder the headings
“About Us – Newsroom - SEC Filings: EDGAR-Online”.  Shareholders will
be provided a copy without charge by writing to the Corporate Secretary, William
L. Wall, First South Bancorp, Inc., P. O. Box 2047, Washington, NC
27889.





Investor
Information


Shareholders,
investors, and analysts interested in additional information may contact William
L. Wall, Chief Financial Officer, First South Bancorp, Inc., P. O. Box 2047,
Washington, NC 27889; or via email to bill.wall@firstsouthnc.com.





Annual
Meeting


The
Annual Meeting of Stockholders of First South Bancorp, Inc. will be held
Thursday, May 20, 2010 at 11:00 a.m. eastern time, at the main office of First
South Bank, 1311 Carolina Avenue, Washington, North Carolina.





General
      Counsel
            Special
      Counsel
            Independent
      AccountantsRodman,
      Holscher, Francisco & Peck, P.A.
            Gaeta
      & Eveson, P.A.
            Turlington
      and Company, L.L.P.320
      North Market Street
            700
      Spring Forest Road, Suite 335
            509
      East Center StreetWashington,
      NC  27889
            Raleigh,
      NC 27609
            Lexington,
      NC 27292


43


COMPARATIVE
STOCK PERFORMANCE GRAPH




The graph
and table which follow show the cumulative total return on the Common Stock for
the period from December 31, 2004 through December 31, 2009 with (1) the total
cumulative return of all companies whose equity securities are traded on the
NASDAQ Stock Market and (2) the total cumulative return of banking companies
traded on the NASDAQ Stock Market. The comparison assumes $100 was invested on
December 31, 2004 in the Company’s Common Stock and in each of the foregoing
indices and assumes reinvestment of dividends.  The stockholder
returns shown on the performance graph are not necessarily indicative of the
future performance of the Common Stock or of any particular index.









12/31/04
                  
                  
                  12/31/05
                  
                  
                  12/31/06
                  
                  
                  12/31/07
                  
                  
                  12/31/08
                  
                  
                  12/31/09First
      South Bancorp Inc.
                  
                  $
                  100.00
                  
                  
                  $
                  141.37
                  
                  
                  $
                  195.82
                  
                  
                  $
                  139.71
                  
                  
                  $
                  82.65
                  
                  
                  $
                  72.50NASDAQ
                  
                  $
                  100.00
                  
                  
                  $
                  101.33
                  
                  
                  $
                  114.01
                  
                  
                  $
                  123.71
                  
                  
                  $
                  73.11
                  
                  
                  $
                  105.61NASDAQ
      Bank
                  
                  $
                  100.00
                  
                  
                  $
                  98.57
                  
                  
                  $
                  111.92
                  
                  
                  $
                  89.33
                  
                  
                  $
                  71.39
                  
                  
                  $
                  60.47


44





First
South Bancorp





1311
Carolina Avenue


P.O. Box
2047


Washington,
North Carolina 27889


(252)
946-4178 • Fax (252) 946-3873


www.firstsouthnc.com