Exhibit
13





Annual
Report to Stockholders for the Fiscal Year Ended December 31, 2008









2008
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
                
                16Consolidated
      Statements of Financial Condition
                
                17Consolidated
      Statements of Operations
                
                18Consolidated
      Statements of Changes in Stockholders' Equity
                
                19Consolidated
      Statements of Cash Flows
                
                20Notes
      to Consolidated Financial Statements
                
                21Board
      of Directors
                
                42Executive
      Officers
                
                42Area
      Executives and Subsidiary Executives
                
                42City
      and Branch Executives
                
                42First
      South Bank Office Locations
                
                43Stockholder
      Information
                
                44Comparative
      Stock Performance Graph
                
                45





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 2008 Annual
Report.





First
South earned net income of $11.0 million in 2008 compared to $17.0 million
earned in 2007.  Diluted earnings per share were $1.12 per share for
2008 versus $1.70 per share for 2007.  At December 31, 2008, our total
assets were $875.9 million; net loans and leases $744.7 million; cash and
investments $99.8 million; deposits $716.4 million; borrowings $52.6 million;
and stockholders’ equity $87.8 million.





The
significance of our 2008 earnings has been the Bank’s ability of managing its
interest-earning assets and interest-bearing liabilities, managing its credit
risk and maintaining a consistent level of revenues from loan fees, deposit fees
and service charges and servicing fee income across both loan and deposit
service offerings.  We accomplished this during one of the most
volatile periods in the banking sector’s history and combined with the Federal
Reserve’s 400 basis point rate cuts since December 2007.





The
economy has moved into a deeper recessionary environment, impacting housing and
real estate property values and financial institutions credit
quality.  During 2008, we recorded provisions for credit losses that
we believe were prudent conservative actions necessary to strengthen our ability
to better manage through this unprecedented economic cycle and support the
long-term success of the Company.  The Company remains profitable, has
a strong capital position in excess of the well-capitalized regulatory
guidelines, and combined with the conservative actions taken this year, should
enhance our future earnings when economic and financial market conditions
improve.





At this
point, it is very difficult to predict how the current economic conditions
affecting the banking system and financial markets will result for 2009, given
the United States government’s recent actions of stabilizing the financial
markets or particular financial institutions.  At best, it will be
challenging.  We are working diligently with our customers to assist
them through these extraordinary times. Our primary focus during 2009 will be
internal; we will focus on managing our balance sheet, credit quality,
maintaining adequate liquidity levels and producing a core net income
stream.





During
2008, your Board of Directors increased the quarterly cash dividend payment rate
by 5.3%, and when combined with declaring four quarterly cash dividends totaling
$0.80 per share, resulted in a dividend payout ratio to our shareholders on
basic earnings of 70.8%.





The
financial results we achieved in 2008 would not have been possible without the
dedication and performance of our professional staff.  We appreciate
the quality of their work and are proud of their many accomplishments achieved
during this volatile period. They are committed to the Bank and to providing our
customers the highest possible standards of service.  We will continue
to invest in our employees, which will ultimately result in improved service to
our customers and enhanced 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 Vann


Tom
Vann


President and


Chief
Executive Officer


F-2


SELECTED
CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA
 
 At or For the Years Ended December
      31,2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006
                                          
                                          
                                          2005
                                          
                                          
                                          2004(dollars
      in thousands, except per share data)Selected Financial Condition
      DataTotal
      assets
                                          
                                          
                                          
                                          
                                          $
                                          875,855
                                          
                                          
                                          $
                                          909,288
                                          
                                          
                                          $
                                          910,548
                                          
                                          
                                          $
                                          834,234
                                          
                                          
                                          $
                                          722,051Loans
      receivable, net
                                          
                                          
                                          
                                          
                                          
                                          744,731
                                          
                                          
                                          
                                          765,083
                                          
                                          
                                          
                                          761,437
                                          
                                          
                                          
                                          708,929
                                          
                                          
                                          
                                          631,816Cash
      and investment securities
                                          
                                          
                                          
                                          
                                          
                                          63,284
                                          
                                          
                                          
                                          73,094
                                          
                                          
                                          
                                          82,258
                                          
                                          
                                          
                                          74,771
                                          
                                          
                                          
                                          52,997Mortgage-backed
      securities
                                          
                                          
                                          
                                          
                                          
                                          32,827
                                          
                                          
                                          
                                          39,120
                                          
                                          
                                          
                                          36,729
                                          
                                          
                                          
                                          22,702
                                          
                                          
                                          
                                          9,209Deposits
                                          
                                          
                                          
                                          
                                          
                                          716,427
                                          
                                          
                                          
                                          761,370
                                          
                                          
                                          
                                          800,188
                                          
                                          
                                          
                                          733,753
                                          
                                          
                                          
                                          628,537Borrowings
                                          
                                          
                                          
                                          
                                          
                                          62,868
                                          
                                          
                                          
                                          52,377
                                          
                                          
                                          
                                          21,450
                                          
                                          
                                          
                                          22,098
                                          
                                          
                                          
                                          25,102Stockholders'
      equity
                                          
                                          
                                          
                                          
                                          
                                          87,821
                                          
                                          
                                          
                                          86,035
                                          
                                          
                                          
                                          78,797
                                          
                                          
                                          
                                          68,190
                                          
                                          
                                          
                                          59,695Selected Operations DataInterest
      income
                                          
                                          
                                          
                                          
                                          $
                                          59,364
                                          
                                          
                                          $
                                          70,078
                                          
                                          
                                          $
                                          67,752
                                          
                                          
                                          $
                                          53,176
                                          
                                          
                                          $
                                          40,180Interest
      expense
                                          
                                          
                                          
                                          
                                          
                                          23,317
                                          
                                          
                                          
                                          29,111
                                          
                                          
                                          
                                          25,607
                                          
                                          
                                          
                                          15,464
                                          
                                          
                                          
                                          9,692Net
      interest income
                                          
                                          
                                          
                                          
                                          
                                          36,047
                                          
                                          
                                          
                                          40,967
                                          
                                          
                                          
                                          42,145
                                          
                                          
                                          
                                          37,712
                                          
                                          
                                          
                                          30,488Provision
      for credit losses
                                          
                                          
                                          
                                          
                                          
                                          4,044
                                          
                                          
                                          
                                          350
                                          
                                          
                                          
                                          933
                                          
                                          
                                          
                                          1,711
                                          
                                          
                                          
                                          968Noninterest
      income
                                          
                                          
                                          
                                          
                                          
                                          10,084
                                          
                                          
                                          
                                          10,137
                                          
                                          
                                          
                                          9,259
                                          
                                          
                                          
                                          8,207
                                          
                                          
                                          
                                          8,750Noninterest
      expenses
                                          
                                          
                                          
                                          
                                          
                                          24,165
                                          
                                          
                                          
                                          22,911
                                          
                                          
                                          
                                          22,207
                                          
                                          
                                          
                                          21,132
                                          
                                          
                                          
                                          19,592Income
      before income taxes
                                          
                                          
                                          
                                          
                                          
                                          17,922
                                          
                                          
                                          
                                          27,843
                                          
                                          
                                          
                                          28,264
                                          
                                          
                                          
                                          23,076
                                          
                                          
                                          
                                          18,678Income
      taxes
                                          
                                          
                                          
                                          
                                          
                                          6,934
                                          
                                          
                                          
                                          10,840
                                          
                                          
                                          
                                          11,072
                                          
                                          
                                          
                                          8,947
                                          
                                          
                                          $
                                          6,966Net
      income
                                          
                                          
                                          
                                          
                                          $
                                          10,988
                                          
                                          
                                          $
                                          17,003
                                          
                                          
                                          $
                                          17,192
                                          
                                          
                                          $
                                          14,129
                                          
                                          
                                          $
                                          11,712Per Share DataEarnings
      per share -basic
                                          
                                          
                                          (1)
                                          
                                          
                                          $
                                          1.13
                                          
                                          
                                          $
                                          1.71
                                          
                                          
                                          $
                                          1.77
                                          
                                          
                                          $
                                          1.49
                                          
                                          
                                          $
                                          1.25Earnings
      per share -diluted
                                          
                                          
                                          (1)
                                          
                                          
                                          
                                          1.12
                                          
                                          
                                          
                                          1.70
                                          
                                          
                                          
                                          1.72
                                          
                                          
                                          
                                          1.41
                                          
                                          
                                          
                                          1.19Dividends
      per share
                                          
                                          
                                          (1)
                                          
                                          
                                          
                                          0.80
                                          
                                          
                                          
                                          0.76
                                          
                                          
                                          
                                          0.68
                                          
                                          
                                          
                                          0.53
                                          
                                          
                                          
                                          0.45Selected Financial Ratios and Other
      DataPerformance
      Ratios:Return
      on average assets
                                          
                                          
                                          
                                          
                                          
                                          
                                          1.22
                                          %
                                          
                                          
                                          1.87
                                          %
                                          
                                          
                                          1.93
                                          %
                                          
                                          
                                          1.78
                                          %
                                          
                                          
                                          1.64
                                          %Return
      on average equity
                                          
                                          
                                          
                                          
                                          
                                          
                                          12.53
                                          
                                          
                                          
                                          20.34
                                          
                                          
                                          
                                          23.45
                                          
                                          
                                          
                                          21.92
                                          
                                          
                                          
                                          20.50Interest
      rate spread
                                          
                                          
                                          
                                          
                                          
                                          
                                          4.18
                                          
                                          
                                          
                                          4.63
                                          
                                          
                                          
                                          4.94
                                          
                                          
                                          
                                          5.04
                                          
                                          
                                          
                                          4.63Net
      interest margin
                                          
                                          
                                          
                                          
                                          
                                          
                                          4.30
                                          
                                          
                                          
                                          4.80
                                          
                                          
                                          
                                          5.05
                                          
                                          
                                          
                                          5.11
                                          
                                          
                                          
                                          4.66Average
      earning assets/average  interest bearing liabilities
                                          
                                          
                                          
                                          
                                          
                                          
                                          117.77
                                          
                                          
                                          
                                          120.41
                                          
                                          
                                          
                                          119.20
                                          
                                          
                                          
                                          118.66
                                          
                                          
                                          
                                          116.63Noninterest
      expense/average assets
                                          
                                          
                                          
                                          
                                          
                                          
                                          2.68
                                          
                                          
                                          
                                          2.53
                                          
                                          
                                          
                                          2.50
                                          
                                          
                                          
                                          2.67
                                          
                                          
                                          
                                          2.75Efficiency
      ratio
                                          
                                          
                                          
                                          
                                          
                                          
                                          52.31
                                          
                                          
                                          
                                          44.99
                                          
                                          
                                          
                                          43.14
                                          
                                          
                                          
                                          45.95
                                          
                                          
                                          
                                          49.87Dividend
      payout ratio
                                          
                                          
                                          
                                          
                                          
                                          
                                          70.80
                                          
                                          
                                          
                                          44.44
                                          
                                          
                                          
                                          38.42
                                          
                                          
                                          
                                          35.87
                                          
                                          
                                          
                                          36.36Quality
      Ratios:Nonperforming
      assets/total assets
                                          
                                          
                                          
                                          
                                          
                                          
                                          2.59
                                          %
                                          
                                          
                                          1.01
                                          %
                                          
                                          
                                          0.37
                                          %
                                          
                                          
                                          0.27
                                          %
                                          
                                          
                                          0.34
                                          %Nonperforming
      loans/total loans
                                          
                                          
                                          
                                          
                                          
                                          
                                          2.01
                                          
                                          
                                          
                                          0.99
                                          
                                          
                                          
                                          0.36
                                          
                                          
                                          
                                          0.32
                                          
                                          
                                          
                                          0.37Allowance
      for credit losses/total loans
                                          
                                          
                                          
                                          
                                          
                                          
                                          1.58
                                          
                                          
                                          
                                          1.27
                                          
                                          
                                          
                                          1.29
                                          
                                          
                                          
                                          1.29
                                          
                                          
                                          
                                          1.30Provision
      for credit losses/total loans
                                          
                                          
                                          
                                          
                                          
                                          
                                          0.54
                                          
                                          
                                          
                                          0.05
                                          
                                          
                                          
                                          0.12
                                          
                                          
                                          
                                          0.24
                                          
                                          
                                          
                                          0.15Capital
      Ratios and Other Data:Equity/total
      assets, end of period
                                          
                                          
                                          
                                          
                                          
                                          
                                          10.03
                                          %
                                          
                                          
                                          9.46
                                          %
                                          
                                          
                                          8.65
                                          %
                                          
                                          
                                          8.18
                                          %
                                          
                                          
                                          8.28
                                          %Average
      equity/average assets
                                          
                                          
                                          
                                          
                                          
                                          
                                          9.72
                                          
                                          
                                          
                                          9.21
                                          
                                          
                                          
                                          8.24
                                          
                                          
                                          
                                          8.13
                                          
                                          
                                          
                                          8.02Full
      service offices
                                          
                                          
                                          
                                          
                                          
                                          
                                          28
                                          
                                          
                                          
                                          29
                                          
                                          
                                          
                                          26
                                          
                                          
                                          
                                          26
                                          
                                          
                                          
                                          25Loans
      serviced for others
                                          
                                          
                                          
                                          
                                          
                                          $
                                          255,510
                                          
                                          
                                          $
                                          254,671
                                          
                                          
                                          $
                                          245,633
                                          
                                          
                                          $
                                          260,632
                                          
                                          
                                          $
                                          277,252
 
 (1)
Adjusted for three-for-two stock splits on May 25, 2006 and April 23,
2004.


F-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 affects 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 that 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 must maintain certain regulatory liquidity
requirements of liquid assets 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 and
lease financing receivables.  The Bank’s primary financing activities
are attracting checking, certificate and savings deposits, and obtaining FHLB
advances.





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 totaled $26.7 million at December 31, 2008 and $24.0 million at
December 31, 2007.  The Bank has other sources of liquidity if a need
for additional funds arises.  Investment and mortgage-backed
securities available for sale totaled $68.6 million at December 31, 2008 and
$86.9 million at December 31, 2007. During the years ended December 31, 2008 and
2007, the Bank sold or exchanged real estate loans of $41.1 million and $42.2
million, respectively.  Borrowings consisting of FHLB advances, junior
subordinated debentures and retail repurchase agreements were $62.9 million at
December 31, 2008 compared to $52.4 million at December 31, 2007.  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 $125.1 million of credit available with the FHLB at December 31, 2008,
compared to $146.0 million at December 31, 2007.





The
Company had $10.3 million of junior subordinated debentures at December 31, 2008
and 2007, 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 “Notes to Consolidated Financial
Statements for additional information.


F-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 $90.1 million at December 31, 2008, compared to
$89.9 million at December 31, 2007.  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, 2008 and 2007.  See
Note 11 of “Notes to Consolidated Financial Statements” for a description of the
Bank’s actual regulatory capital amounts and ratios as of December 31, 2008 and
2007.





Stockholders'
equity was $87.8 million at December 31, 2008, compared to $86.0 million at
December 31, 2007. Net income was $11.0 million for fiscal 2008, compared to
$17.0 million for fiscal 2007.  There were 9,738,096 shares of common
stock outstanding at December 31, 2008, net of 1,516,126 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, 2008.





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
                        
                        $
                        52,558
                        
                        
                        $
                        10,000
                        
                        
                        $
                        42,558
                        
                        
                        $
                        -
                        
                        
                        $
                        -Junior
      subordinated debentures
                        
                        
                        10,310
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        10,310Lease
      obligations
                        
                        
                        1,783
                        
                        
                        
                        540
                        
                        
                        
                        725
                        
                        
                        
                        518
                        
                        
                        
                        -Deposits
                        
                        
                        716,427
                        
                        
                        
                        654,874
                        
                        
                        
                        58,490
                        
                        
                        
                        3,063
                        
                        
                        
                        -Total
      contractual cash obligations
                        
                        $
                        781,078
                        
                        
                        $
                        665,414
                        
                        
                        $
                        101,773
                        
                        
                        $
                        3,581
                        
                        
                        $
                        10,310





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
                        
                        $
                        66,428
                        
                        
                        $
                        55,327
                        
                        
                        $
                        11,101
                        
                        
                        $
                        -
                        
                        
                        $
                        -Undrawn
      balances on lines of credit and undrawn balances on credit
      reserves
                        
                        
                        51,504
                        
                        
                        
                        783
                        
                        
                        
                        2,883
                        
                        
                        
                        6,108
                        
                        
                        
                        41,730Standby
      letters of credit
                        
                        
                        2,384
                        
                        
                        
                        2,384
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Total
      other commitments
                        
                        $
                        120,316
                        
                        
                        $
                        58,494
                        
                        
                        $
                        13,984
                        
                        
                        $
                        6,108
                        
                        
                        $
                        41,730





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, 2008 is not material and has not been included in
Table 1 above.




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.


F-5





Interest
rate risk and trends, liquidity and capital ratio requirements are reported to
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
approach in managing the Bank's interest rate risk has been to increase interest
sensitive assets such as commercial loans, consumer loans and lease financing
receivables.  The Bank had $710.4 million of commercial loans,
consumer loans and lease receivables at December 31, 2008, compared to $724.8
million at December 31, 2007.  The Bank had $5.6 million of loans held
for sale at December 31, 2008, compared to $7.5 million at December 31,
2007.  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 $68.6 million of
investment and mortgage-backed securities classified as available for sale at
December 31, 2008, compared to $86.9 million at December 31, 2007.





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
measures interest rate risk 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 400 basis points rate cuts since December 2007, and the
current federal funds rate at 0% to 0.25%, 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 only in the event of sudden and sustained
increases in market interest rates for the various rate shock levels at December
31, 2008. At December 31, 2008, 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 IncomeChange in Rates
                
                Amount
                
                
                Change
                
                
                % Change
                
                
                Amount
                
                
                Change
                
                
                % Change(Dollars
      in thousands)+
      300 bp
                
                $
                114,594
                
                
                $
                4,771
                
                
                
                4.3
                %
                
                $
                41,316
                
                
                $
                4,188
                
                
                
                11.3
                %+
      200 bp
                
                
                113,387
                
                
                
                3,564
                
                
                
                3.2
                
                
                
                39,986
                
                
                
                2,858
                
                
                
                7.7+
      100 bp
                
                
                111,699
                
                
                
                1,876
                
                
                
                1.7
                
                
                
                38,626
                
                
                
                1,498
                
                
                
                4.0Base
                
                
                109,823
                
                
                
                -
                
                
                
                -
                
                
                
                37,128
                
                
                
                -
                
                
                
                -


F-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 three years ended
December 31, 2008, 2007, and 2006, 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 a decline in the net
interest margin, significantly influenced by the Federal Reserve’s 400 basis
point rate cuts since December 2007.  It has also been influenced by
the decline in average earning assets attributable to a slow down in loan
originations in the current recessionary economic environment, the increased
volume of nonperforming loans and other real estate owned, as discussed
below.


F-7




Table
3 - Rate/Volume Analysis
 Year Ended December 31,
                        
                        
                        Year Ended December 31,2008 vs. 2007
                        
                        
                        2007 vs. 2006Increase (Decrease) Due to
                        
                        
                        Increase (Decrease) Due to(In thousands)Rate/
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        Rate/Volume
                        
                        
                        Rate
                        
                        
                        Volume
                        
                        
                        Total
                        
                        
                        Volume
                        
                        
                        Rate
                        
                        
                        Volume
                        
                        
                        TotalInterest
      income:Loans
      receivable
                        
                        $
                        (375
                        )
                        
                        $
                        (9,473
                        )
                        
                        $
                        55
                        
                        
                        $
                        (9,793
                        )
                        
                        $
                        609
                        
                        
                        $
                        1,157
                        
                        
                        $
                        11
                        
                        
                        $
                        1,777Investment
      securities
                        
                        
                        (331
                        )
                        
                        
                        (71
                        )
                        
                        
                        10
                        
                        
                        
                        (392
                        )
                        
                        
                        (51
                        )
                        
                        
                        (213
                        )
                        
                        
                        4
                        
                        
                        
                        (260
                        )Mortgage-backed
      securities
                        
                        
                        (126
                        )
                        
                        
                        (67
                        )
                        
                        
                        4
                        
                        
                        
                        (189
                        )
                        
                        
                        343
                        
                        
                        
                        (8
                        )
                        
                        
                        (2
                        )
                        
                        
                        333Other
      interest-earning assets
                        
                        
                        (53
                        )
                        
                        
                        (310
                        )
                        
                        
                        23
                        
                        
                        
                        (340
                        )
                        
                        
                        452
                        
                        
                        
                        8
                        
                        
                        
                        16
                        
                        
                        
                        476Total
      earning assets
                        
                        
                        (885
                        )
                        
                        
                        (9,921
                        )
                        
                        
                        92
                        
                        
                        
                        (10,714
                        )
                        
                        
                        1,353
                        
                        
                        
                        944
                        
                        
                        
                        29
                        
                        
                        
                        2,326Interest
      expense:Deposits
                        
                        
                        (1,353
                        )
                        
                        
                        (5,313
                        )
                        
                        
                        261
                        
                        
                        
                        (6,405
                        )
                        
                        
                        446
                        
                        
                        
                        3,137
                        
                        
                        
                        58
                        
                        
                        
                        3,641FHLB
      advances
                        
                        
                        1,404
                        
                        
                        
                        (117
                        )
                        
                        
                        (357
                        )
                        
                        
                        930
                        
                        
                        
                        (162
                        )
                        
                        
                        (27
                        )
                        
                        
                        7
                        
                        
                        
                        (182
                        )Other
      interest-bearing liabilities
                        
                        
                        181
                        
                        
                        
                        (432
                        )
                        
                        
                        (68
                        )
                        
                        
                        (319
                        )
                        
                        
                        4
                        
                        
                        
                        41
                        
                        
                        
                        0
                        
                        
                        
                        45Total
      interest-bearing liabilities
                        
                        
                        232
                        
                        
                        
                        (5,862
                        )
                        
                        
                        (164
                        )
                        
                        
                        (5,794
                        )
                        
                        
                        288
                        
                        
                        
                        3,151
                        
                        
                        
                        65
                        
                        
                        
                        3,504Change
      in net interest income
                        
                        $
                        (1,117
                        )
                        
                        $
                        (4,059
                        )
                        
                        $
                        256
                        
                        
                        $
                        (4,920
                        )
                        
                        $
                        1,065
                        
                        
                        $
                        (2,207
                        )
                        
                        $
                        (36
                        )
                        
                        $
                        (1,178
                        )
 
 Year Ended December 31,
                          
                          
                          Year Ended December 31,2006 vs. 2005
                          
                          
                          2005 vs. 2004Increase (Decrease) Due to
                          
                          
                          Increase (Decrease) Due to(In thousands)Rate/
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          Rate/Volume
                          
                          
                          Rate
                          
                          
                          Volume
                          
                          
                          Total
                          
                          
                          Volume
                          
                          
                          Rate
                          
                          
                          Volume
                          
                          
                          TotalInterest income:Loans
      receivable
                          
                          $
                          4,544
                          
                          
                          $
                          7,610
                          
                          
                          $
                          687
                          
                          
                          $
                          12,841
                          
                          
                          $
                          5,483
                          
                          
                          $
                          7,067
                          
                          
                          $
                          1,055
                          
                          
                          $
                          13,605Investment
      securities
                          
                          
                          978
                          
                          
                          
                          (221
                          )
                          
                          
                          (111
                          )
                          
                          
                          646
                          
                          
                          
                          (535
                          )
                          
                          
                          (349
                          )
                          
                          
                          67
                          
                          
                          
                          (817
                          )Mortgage-backed
      securities
                          
                          
                          1,181
                          
                          
                          
                          11
                          
                          
                          
                          25
                          
                          
                          
                          1,217
                          
                          
                          
                          (36
                          )
                          
                          
                          (23
                          )
                          
                          
                          2
                          
                          
                          
                          (57
                          )Other
      interest-earning assets
                          
                          
                          (202
                          )
                          
                          
                          170
                          
                          
                          
                          (96
                          )
                          
                          
                          (128
                          )
                          
                          
                          108
                          
                          
                          
                          72
                          
                          
                          
                          85
                          
                          
                          
                          265Total
      earning assets
                          
                          
                          6,501
                          
                          
                          
                          7,570
                          
                          
                          
                          505
                          
                          
                          
                          14,576
                          
                          
                          
                          5,020
                          
                          
                          
                          6,767
                          
                          
                          
                          1,209
                          
                          
                          
                          12,996Interest
      expense:Deposits
                          
                          
                          1,657
                          
                          
                          
                          6,877
                          
                          
                          
                          783
                          
                          
                          
                          9,317
                          
                          
                          
                          1,233
                          
                          
                          
                          3,840
                          
                          
                          
                          530
                          
                          
                          
                          5,603FHLB
      advances
                          
                          
                          192
                          
                          
                          
                          127
                          
                          
                          
                          201
                          
                          
                          
                          520
                          
                          
                          
                          (184
                          )
                          
                          
                          133
                          
                          
                          
                          (93
                          )
                          
                          
                          (144
                          )Other
      interest-bearing liabilities
                          
                          
                          28
                          
                          
                          
                          270
                          
                          
                          
                          9
                          
                          
                          
                          307
                          
                          
                          
                          63
                          
                          
                          
                          221
                          
                          
                          
                          28
                          
                          
                          
                          312Total
      interest-bearing liabilities
                          
                          
                          1,877
                          
                          
                          
                          7,274
                          
                          
                          
                          993
                          
                          
                          
                          10,144
                          
                          
                          
                          1,112
                          
                          
                          
                          4,194
                          
                          
                          
                          465
                          
                          
                          
                          5,771Change
      in net interest income
                          
                          $
                          4,624
                          
                          
                          $
                          296
                          
                          
                          $
                          (488
                          )
                          
                          $
                          4,432
                          
                          
                          $
                          3,908
                          
                          
                          $
                          2,573
                          
                          
                          $
                          744
                          
                          
                          $
                          7,225


F-8




Table
4 - Yield/Cost Analysis
 
 Year Ended December 31,
                    
                    
                    Year Ended December 31,
                    
                    
                    Year Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Average
                    
                    
                    
                    
                    
                    
                    
                    
                    Average
                    
                    
                    
                    
                    
                    
                    
                    
                    AverageAverage
                    
                    
                    
                    
                    
                    Yield/
                    
                    
                    Average
                    
                    
                    
                    
                    
                    Yield/
                    
                    
                    Average
                    
                    
                    
                    
                    
                    Yield/Balance
                    
                    
                    Interest
                    
                    
                    Cost
                    
                    
                    Balance
                    
                    
                    Interest
                    
                    
                    Cost
                    
                    
                    Balance
                    
                    
                    Interest
                    
                    
                    CostInterest
      earning assets:Loans
      receivable
                    
                    $
                    751,151
                    
                    
                    $
                    55,182
                    
                    
                    
                    7.35
                    %
                    
                    $
                    755,502
                    
                    
                    $
                    64,975
                    
                    
                    
                    8.60
                    %
                    
                    $
                    748,296
                    
                    
                    $
                    63,198
                    
                    
                    
                    8.45
                    %Investment
      securities
                    
                    
                    43,685
                    
                    
                    
                    1,948
                    
                    
                    
                    4.46
                    
                    
                    
                    50,891
                    
                    
                    
                    2,340
                    
                    
                    
                    4.60
                    
                    
                    
                    51,919
                    
                    
                    
                    2,600
                    
                    
                    
                    5.01Mortgage-backed
      securities
                    
                    
                    34,827
                    
                    
                    
                    1,869
                    
                    
                    
                    5.37
                    
                    
                    
                    37,097
                    
                    
                    
                    2,058
                    
                    
                    
                    5.55
                    
                    
                    
                    30,941
                    
                    
                    
                    1,725
                    
                    
                    
                    5.58Other
      interest-earning assets
                    
                    
                    9,348
                    
                    
                    
                    365
                    
                    
                    
                    3.90
                    
                    
                    
                    10,102
                    
                    
                    
                    705
                    
                    
                    
                    6.98
                    
                    
                    
                    3,397
                    
                    
                    
                    229
                    
                    
                    
                    6.74Total
      earning assets
                    
                    
                    839,011
                    
                    
                    
                    59,364
                    
                    
                    
                    7.08
                    
                    
                    
                    853,592
                    
                    
                    
                    70,078
                    
                    
                    
                    8.21
                    
                    
                    
                    834,553
                    
                    
                    
                    67,752
                    
                    
                    
                    8.12Nonearning
      assets
                    
                    
                    63,657
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    53,741
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    55,349Total
      assets
                    
                    $
                    902,668
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    907,333
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    889,902Interest
      bearing liabilities:Time
      deposits
                    
                    $
                    479,642
                    
                    
                    
                    19,447
                    
                    
                    
                    4.05
                    
                    
                    $
                    505,142
                    
                    
                    
                    24,343
                    
                    
                    
                    4.82
                    
                    
                    $
                    502,167
                    
                    
                    
                    21,674
                    
                    
                    
                    4.32Demand
      deposits
                    
                    
                    147,978
                    
                    
                    
                    1,587
                    
                    
                    
                    1.07
                    
                    
                    
                    157,125
                    
                    
                    
                    3,129
                    
                    
                    
                    1.99
                    
                    
                    
                    145,206
                    
                    
                    
                    2,153
                    
                    
                    
                    1.48Savings
                    
                    
                    19,734
                    
                    
                    
                    61
                    
                    
                    
                    0.31
                    
                    
                    
                    18,584
                    
                    
                    
                    28
                    
                    
                    
                    0.15
                    
                    
                    
                    20,993
                    
                    
                    
                    32
                    
                    
                    
                    0.15FHLB
      advances
                    
                    
                    45,654
                    
                    
                    
                    1,389
                    
                    
                    
                    3.04
                    
                    
                    
                    11,246
                    
                    
                    
                    459
                    
                    
                    
                    4.08
                    
                    
                    
                    15,035
                    
                    
                    
                    641
                    
                    
                    
                    4.26Junior
      subordinated debentures
                    
                    
                    10,310
                    
                    
                    
                    658
                    
                    
                    
                    6.38
                    
                    
                    
                    10,310
                    
                    
                    
                    839
                    
                    
                    
                    8.14
                    
                    
                    
                    10,310
                    
                    
                    
                    815
                    
                    
                    
                    7.90Repurchase
      agreements
                    
                    
                    9,105
                    
                    
                    
                    175
                    
                    
                    
                    1.92
                    
                    
                    
                    6,472
                    
                    
                    
                    313
                    
                    
                    
                    4.84
                    
                    
                    
                    6,417
                    
                    
                    
                    292
                    
                    
                    
                    4.55Total
      interest-bearing liabilities
                    
                    
                    712,423
                    
                    
                    
                    23,317
                    
                    
                    
                    3.27
                    
                    
                    
                    708,879
                    
                    
                    
                    29,111
                    
                    
                    
                    4.11
                    
                    
                    
                    700,128
                    
                    
                    
                    25,607
                    
                    
                    
                    3.66Noninterest
      bearing demand deposits
                    
                    
                    92,227
                    
                    
                    
                    0
                    
                    
                    
                    0.00
                    
                    
                    
                    103,571
                    
                    
                    
                    0
                    
                    
                    
                    0.00
                    
                    
                    
                    104,693
                    
                    
                    
                    0
                    
                    
                    
                    0.00Total
      sources of funds
                    
                    
                    804,650
                    
                    
                    
                    23,317
                    
                    
                    
                    2.90
                    
                    
                    
                    812,450
                    
                    
                    
                    29,111
                    
                    
                    
                    3.58
                    
                    
                    
                    804,821
                    
                    
                    
                    25,607
                    
                    
                    
                    3.18Other
      liabilities and stockholders'equity:Other
      liabilities
                    
                    
                    10,323
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    11,275
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    11,751Stockholders'
      equity
                    
                    
                    87,695
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    83,608
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    73,330Total
      liabilities and stockholders' equity
                    
                    $
                    902,668
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    907,333
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    889,902Net
      interest income
                    
                    
                    
                    
                    
                    $
                    36,047
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    40,967
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    42,145Interest
      rate spread (1)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4.18
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4.63
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4.94
                    %Net
      yield on earning assets (2)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4.30
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4.80
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    5.05
                    %Ratio
      of earning assets to interest bearing liabilities
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    117.77
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    120.41
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    119.20
                    %
 
 (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.




F-9




Results of
Operations




Comparison of Financial Condition at
December 31, 2008 and 2007.Total assets were $875.9
million at December 31, 2008, compared to $909.3 million at December 31,
2007.  Average earning assets were $839.0 million for the year ended
December 31, 2008, compared to $853.6 million for the year ended December 31,
2007, reflecting the net change in the volume and mix of loan and leases
receivable and investment securities.  Earning assets were 92.3% of
total assets at December 31, 2008, compared to 93.6 % at December 31,
2007.




Investment
and mortgage-backed securities declined to $69.4 million at December 31, 2008,
from $88.2 million at December 31, 2007.  The Bank had $13.0 million
of maturities of investment securities available for sale during fiscal 2008,
compared to $9.0 million of maturities during fiscal 2007.  The Bank
purchased no investment securities available for sale during fiscal 2008,
compared to $500,000 purchased in fiscal 2007.  The Bank securitized
$3.4 million of mortgage loans held for sale into mortgage-backed securities
during fiscal 2008, compared to $6.9 million securitized during fiscal 2007, in
order to support future liquidity management needs.  The Bank sold
$4.0 million of mortgage-backed securities available for sale during fiscal
2008, compared to none sold in fiscal 2007.





Loans and
lease receivables, net of allowance for loan and lease losses and deferred loan
fees, declined to $744.7 million at December 31, 2008 from $765.1 million at
December 31, 2007.  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 $255.5 million at
December 31, 2008 from $254.7 million serviced at December 31,
2007.





Commercial
loans declined to $597.0 million at December 31, 2008 from $610.0 million at
December 31, 2007. During 2008, certain commercial loans held were the subject
of foreclosures and transferred to other real estate owned, as discussed
below.   The Bank has discontinued 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 increased to $101.8 million at December 31, 2008
from $101.7 million at December 31, 2007; while lease receivables declined to
$11.6 million at December 31, 2008 from $13.1 million at December 31, 2007.
Commercial loan, consumer loan and lease receivables originations were $280.3
million during fiscal 2008, compared to $315.8 million during fiscal
2007.





Residential
mortgage loans declined to $47.0 million at December 31, 2008 from $51.2 million
at December 31, 2007, reflecting principal repayments, originations, sales and
securitizations.  The Bank originated $48.9 million of held for sale
residential mortgage loans during fiscal 2008, compared to $47.1 million during
fiscal 2007.  The Bank also originated $31.1 million of residential
mortgage loans for investors during fiscal 2008, compared to $38.4 million
during fiscal 2007.  The Bank sold $37.7 million of loans held for
sale during fiscal 2008, compared to $35.4 million sold during fiscal 2007, to
reduce its exposure to credit risk, to support liquidity management and for
funding the decline in deposits discussed below.





Nonperforming
loans were $10.7 million at December 31, 2008, compared to $7.6 million at
December 31, 2007. Restructured loans were $4.3 million at December 31, 2008,
compared to none at December 31, 2007. The current level of nonperforming and
restructured loans, consisting primarily of residential and commercial real
estate loans, is attributable to current recessionary economic conditions and
decreasing property values in the Bank’s market area.  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
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.





Other
real estate owned increased to $7.7 million at December 31, 2008 from $1.6
million at December 31, 2007, reflecting foreclosures of certain nonperforming
loans.  Other real estate owned consists primarily of single family
residential properties, developed building lots and a partially 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 $772,000 of fair value adjustments to other real estate owned
during fiscal 2008, compared to none in fiscal 2007.


F-10




Goodwill
related to prior period acquisitions was $4.2 million at December 31, 2008 and
2007, respectively, and is not amortized according to provisions of financial
accounting standards.  The unamortized balance of the Company’s
goodwill is tested for impairment quarterly. The Company has performed annual
impairment testing and determined there was no impairment of goodwill as of
December 31, 2008 or December 31, 2007.





Total
deposits declined to $716.4 million at December 31, 2008 from $761.4 million at
December 31, 2007.  The Bank continues to compete in its market area
for lower costing core demand deposits. During 2008 and amid intense
competition, demand accounts declined to $223.4 million at December 31, 2008
from $243.6 million at December 31, 2007.  Certificates of deposit
declined to $466.5 million at December 31, 2008 from $500.2 million at December
31, 2007.  The Bank attempts to manage its cost of deposits by
monitoring the volume and rates being paid on maturing certificates of deposits
in relationship to current funding needs and competitive market interest
rates.  During fiscal 2008, a period of declining Fed rate
adjustments, the Bank did not renew certain maturing high rate time deposits and
began repricing new and maturing time deposits at competitive market
rates.  The Bank also replaced certain maturing higher costing time
deposits with lower costing FHLB borrowings, providing an effective means of
managing its overall cost of funds, as discussed below.





Total
borrowings increased to $62.9 million at December 31, 2008 from $52.4 million at
December 31, 2007.  FHLB advances increased to $45.0 million at
December 31, 2008 from $35.0 million at December 31, 2007, as the Bank repaid
$35.0 million of daily rate credit advances and borrowed $45.0 million of fixed
rated advances at terms ranging from 18 to 36 months at a weighted average cost
of 3.01%, in order to reduce its long-term funding cost.  Junior
subordinated debentures were $10.3 million at December 31, 2008 and 2007,
respectively.  Repurchase agreements representing funds held in cash
management accounts for commercial banking customers increased to $7.6 million
at December 31, 2008 from $7.1 million at December 31, 2007.





Stockholders'
equity increased to $87.8 million at December 31, 2008, from $86.0 million at
December 31, 2007.  The Company’s equity to assets ratio increased to
10.0% at December 31, 2008 from 9.5% at December 31,
2007.  Accumulated other comprehensive income was $1.2 million at
December 31, 2008, compared to $377,000 at December 31, 2007, reflecting
increased unrealized gains on available for sale securities, net of deferred
income taxes.  The increase in accumulated other comprehensive income
is due primarily to a decline in interest rates during 2008.





The
Company declared four quarterly cash dividends each during fiscal 2008 and 2007,
totaling $0.80 and $0.76 per share respectively.  These cash dividend
payments reflect dividend payout ratios on basic earnings of 70.8% for fiscal
2008 and 44.4% for fiscal 2007.  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 purchased 140,241 shares of its common stock during fiscal 2008 through
open market and private purchases, compared to 244,198 shares purchased in
fiscal 2007.  Shares purchased are held as treasury stock, at
cost.  Treasury shares were 1,516,126 totaling $32.2 million at
December 31, 2008, compared to 1,445,567 shares totaling $30.9 million at
December 31, 2007.  Treasury shares are used for general corporate
purposes including the exercise of stock options and funding shares for
potential future stock splits.  There were 90,499 shares issued on the
exercise of stock options during fiscal 2008, compared to 303,080 shares issued
during fiscal 2007.  During fiscal 2008, 20,817 shares were tendered
to pay for the exercise price of stock options being exercised and income taxes
incident to such option exercises, compared to 38,360 shares tendered during
fiscal 2007.





Comparison of Operating Results for
the Years Ended December 31, 2008 and 2007.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.  The average numbers of diluted shares
were 9,781,761 for fiscal 2008 and 10,027,728 for fiscal 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.





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.


F-11





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 (net interest
income divided by average interest-earning assets) was 4.3% for fiscal 2008,
compared to 4.8% for fiscal 2007.  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 4.2% for fiscal 2008, compared to
4.6% for fiscal 2007.  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.  The Bank provided $4.0 million for credit losses
during fiscal 2008, compared to $350,000 in fiscal 2007.  These
provisions were necessary to absorb probable losses 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 portfolio, unfunded loan commitments and past loss
experience.  The Bank's methodology for evaluating its allowance for
credit losses includes amounts specifically allocated to loans and leases that
are individually determined to be impaired, and general allowances allocated to
groups of loans and leases not individually assessed for
impairment.





The Bank
uses an analytical asset classification process to determine the adequacy of its
allowance for credit losses and necessary provisions for credit
losses.  The loan and lease portfolio is reviewed quarterly and
delinquent loans are individually analyzed.  Consideration is given to
the loan status, payment history, repayment ability, probability of repayment,
and loan-to-value percentages.  Loans are classified in categories
applicable to their circumstances as a result of this analysis.  After
reviewing current economic conditions, changes in delinquency status, and actual
losses incurred by the Bank, management establishes an appropriate allowance
percentage applicable to each category of assets, and provisions for credit
losses are recorded when necessary to bring the allowances to a level consistent
with this analysis.





The
allowance for loan and lease losses and unfunded loan commitments was $11.6
million and $340,000, respectively, at December 31, 2008, compared to $9.5
million and $403,000 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.  See
Note 1 and Note 4 of “Notes to Consolidated Financial Statements” for additional
information about the allowance for credit losses as of December 31, 2008 and
2007.





Noninterest
Income.  Noninterest income was $10.1 million for both fiscal
2008 and 2007, respectively.  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 sales of loans 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
increased to $7.8 million for fiscal 2008 from $7.3 million for fiscal
2007.  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 $587,000 for fiscal 2008 from $519,000 for
fiscal 2007.  The volume of loans sold increased to $37.7 million
during fiscal 2008, from $35.4 million sold during fiscal 2007.  The
Bank may sell 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.


F-12





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.





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 includes the $772,000 fair value adjustments on other
real estate owned discussed above, and increased FDIC insurance
premiums.  One-time FDIC insurance assessment credits received under
the Federal Deposit Reform Act of 2005 beginning in June 2007 through June 2008
have been exhausted, and as a result, FDIC insurance premiums increased 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 have remained relatively constant during fiscal 2008 and
2007.





The
efficiency ratio (noninterest expenses as a percentage of net interest income
plus noninterest income) was 52.3% for fiscal 2008, compared to 45.0% for fiscal
2007.  The efficiency ratio measures the proportion of net operating
revenues that are absorbed by overhead expenses.





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.





Comparison of Operating Results for
the Years Ended December 31, 2007 and 2006.Net income
was $17.0 million for the year ended December 31, 2007, compared to $17.2
million for the year ended December 31, 2006.  Diluted earnings per
share were $1.70 per share for fiscal 2007 and $1.72 per share for fiscal
2006.  The average numbers of diluted shares were 10,027,728 for
fiscal 2007 and 10,002,869 for fiscal 2006.  Return on average assets
and return on average equity was 1.9% and 20.3% respectively for fiscal 2007,
compared to 1.9% and 23.5% for fiscal 2006.





Interest
Income.  Interest income increased to $70.1 million for fiscal
2007 from $67.8 million for fiscal 2006.  During 2007, the increase in
interest income resulted from a combination of increases in interest rates and
in the volume of interest-earning assets, enabling the Bank to earn an increased
level of interest income. The average balance of interest-earning assets
increased to $853.6 million for fiscal 2007, from $834.6 million for fiscal
2006.  The yield on average interest-earning assets was 8.2% for
fiscal 2007 and 8.1% for fiscal 2006.





Interest
Expense.  Interest expense increased to $29.1 million for
fiscal 2007 from $25.6 million for fiscal 2006.  The increase in
interest expense also reflects increases in interest rates and the volume of
average interest-bearing liabilities, plus a decline in noninterest-bearing
demand accounts.  The average balance of interest-bearing liabilities
increased to $708.9 million for fiscal 2007 from $700.1 million for fiscal
2006.  The average balance of noninterest-bearing deposits declined to
$103.6 million for fiscal 2007 from $104.7 million for fiscal 2006. The average
cost of funds was 3.6% for 2007, compared to 3.2% for 2006, reflecting the
rising interest rate environment during fiscal 2007, combined with the increased
volume of average interest-bearing liabilities.





Net Interest
Income.  Net interest income declined to $41.0 million for
fiscal 2007 from $42.1 million for fiscal 2006. The decline in net interest
income during 2007 is attributable to a $2.2 million greater volume of interest
paid on interest-bearing liabilities due to changing interest rates, than on
interest received from interest earning assets. The net yield on
interest-earning assets was 4.8% for fiscal 2007, compared to 5.1% for fiscal
2006.  The Bank's interest rate spread was 4.6% for fiscal 2007 and
4.9% for fiscal 2006.





Provision for
Credit  Losses.  The Bank provided $350,000 for
credit losses during fiscal 2007, compared to $933,000 for fiscal 2006. These
provisions were necessary to absorb probable losses in the loan and lease
portfolio and to support the inherent risks associated with growth in commercial
and consumer loans. The Bank maintains general and specific allowances for loan
and lease losses and unfunded 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.


F-13





The
allowance for loan and lease losses and unfunded commitments were $9.5 million
and $403,000, respectively, at December 31, 2007, compared to $9.2 million and
$765,000 at December 31, 2006.  The ratio of the allowance for credit
losses to total loans was 1.3% at both December 31, 2007 and 2006, which the
Bank believes is appropriate.





Nonperforming
loans were $7.6 million at December 31, 2007, compared to $2.7 million at
December 31, 2006.  The increase in nonperforming loans consisted
primarily of residential and commercial real estate credits.  The
ratio of non-performing loans to total loans was 1.0% at December 31, 2007,
compared to .4% at December 31, 2006.





Noninterest
Income.  Noninterest income increased to $10.1 million for
fiscal 2007 from $9.3 million for fiscal 2006.  Fees and service
charges increased to $7.3 million for fiscal 2007 from $6.7 million for fiscal
2006, reflecting the volume of loan, deposit account, and insufficient funds
transactions processed during each period, and the collection of related fees
and service charges.  Servicing fee income on loans serviced for
others was $651,000 for fiscal 2007, compared to $666,000 for fiscal
2006.  Loans serviced for others were $254.7 million at year end 2007
compared to $245.6 million at year end 2006.





Gains
from sales of mortgage loans increased to $519,000 for fiscal 2007 from $330,000
for fiscal 2006.  The volume of loans sold increased to $35.4 million
during fiscal 2007, from $1.2 million sold during fiscal 2006.  Net
proceeds from loan sales provide additional liquidity necessary to support the
Bank’s operating, financing and lending activities.





Noninterest
Expenses.  Noninterest expenses increased to $22.9 million for
fiscal 2007 from $22.2 million in fiscal 2006.  The Company's
efficiency ratio was 45.0% for fiscal 2007, compared to 43.1% for fiscal
2006.  The largest single component of these expenses, compensation
and fringe benefits, increased to $14.0 million for fiscal 2007 from $13.6
million for fiscal 2006.  Full-time equivalent employees increased to
287 at December 31, 2007, compared 275 at December 31, 2006.  This net
growth in personnel resulted from opening two full-service banking offices and
two loan production offices in 2007 and the administrative staff required to
support those new offices.





Data
processing expense has grown proportionately with the growth in customer
accounts and transaction activity primarily attributable to the growth in
earning assets and deposits.  Other noninterest expenses including
advertising, deposit insurance, premises and equipment, payroll and other taxes,
repairs and maintenance, and office expenses also grew proportionately from
period to period in relationship with the growth in earning assets and deposit
accounts.





Income
Taxes.  Income taxes declined to $10.8 million for fiscal 2007
from $11.1 million for fiscal 2006. The decrease in income taxes is a direct
result of the net decline of pretax earnings to $27.8 million for fiscal 2007
from $28.3 million for fiscal 2006.  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 38.9% for fiscal 2007,
compared to 39.2% for 2006.





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.


F-14





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.





New Accounting
Pronouncements





See Note
1 of the “Notes to Consolidated Financial Statements” for a description of new
accounting pronouncements including the respective effective dates of adoption
and effects on results of operations and financial condition.





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.





F-15


[Letterhead
of Turlington and Company, L.L.P.]




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, 2008 and 2007, 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,
2008.  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, 2008 and 2007 and the results of their
operations, and their cash flows each of the years in the three-year period
ended December 31, 2008 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, 2008, 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 5, 2009 expressed an
unqualified opinion.




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




Lexington,
North Carolina


March 5,
2009


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


F-16


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF FINANCIAL CONDITION
 December
31, 2008 and 2007








2008
                
                
                2007ASSETSCash
      and due from banks
                
                $
                20,888,676
                
                
                $
                22,273,592Interest-bearing
      deposits in financial institutions
                
                
                5,831,683
                
                
                
                1,755,695Investment
      securities - available for sale
                
                
                36,563,646
                
                
                
                49,064,278Mortgage-backed
      securities - available for sale
                
                
                31,995,157
                
                
                
                37,828,064Mortgage-backed
      securities - held for investment
                
                
                832,221
                
                
                
                1,291,762Loans
      receivable, netHeld
      for sale
                
                
                5,566,262
                
                
                
                7,515,626Held
      for investment
                
                
                739,165,035
                
                
                
                757,567,279Premises
      and equipment, net
                
                
                9,049,929
                
                
                
                9,433,399Real
      estate owned
                
                
                7,710,560
                
                
                
                1,601,704Federal
      Home Loan Bank of Atlanta stock, at cost which approximates
      market
                
                
                3,658,600
                
                
                
                3,210,100Accrued
      interest receivable
                
                
                3,786,760
                
                
                
                5,103,405Goodwill
                
                
                4,218,576
                
                
                
                4,218,576Mortgage
      servicing rights
                
                
                1,005,725
                
                
                
                1,150,616Identifiable
      intangible assets
                
                
                165,060
                
                
                
                196,500Income
      tax receivable
                
                
                1,679,191
                
                
                
                1,403,567Prepaid
      expenses and other assets
                
                
                3,738,040
                
                
                
                5,673,548Total
      assets
                
                $
                875,855,121
                
                
                $
                909,287,711LIABILITIES
      AND STOCKHOLDERS' EQUITYDeposits:Demand
                
                $
                223,365,542
                
                
                $
                243,647,606Savings
                
                
                26,555,881
                
                
                
                17,497,763Large
      denomination certificates of deposit
                
                
                207,102,876
                
                
                
                204,509,581Other
      time
                
                
                259,402,497
                
                
                
                295,714,633Total
      deposits
                
                
                716,426,796
                
                
                
                761,369,583Borrowed
      money
                
                
                52,558,492
                
                
                
                42,067,421Junior
      subordinated debentures
                
                
                10,310,000
                
                
                
                10,310,000Other
      liabilities
                
                
                8,738,808
                
                
                
                9,505,385Total
      liabilities
                
                
                788,034,096
                
                
                
                823,252,389Commitments
      and contingencies (Note 14)Common
      stock, $.01 par value, 25,000,000 shares authorized, 11,254,222 issued;
      9,738,096 and 9,808,655 shares outstanding, respectively
                
                
                97,381
                
                
                
                98,087Additional
      paid-in capital
                
                
                35,924,426
                
                
                
                36,761,824Retained
      earnings, substantially restricted
                
                
                82,867,095
                
                
                
                79,679,027Treasury
      stock at cost
                
                
                (32,247,365
                )
                
                
                (30,880,120
                )Accumulated
      other comprehensive income, net
                
                
                1,179,488
                
                
                
                376,504Total
      stockholders' equity
                
                
                87,821,025
                
                
                
                86,035,322Total
      liabilities and stockholders' equity
                
                $
                875,855,121
                
                
                $
                909,287,711




F-17


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 Years
Ended December 31, 2008, 2007 and 2006








2008
                
                
                2007
                
                
                2006Interest
      incomeInterest
      and fees on loans
                
                $
                55,182,193
                
                
                $
                64,975,487
                
                
                $
                63,198,115Interest
      and dividends on investments and deposits
                
                
                4,181,602
                
                
                
                5,102,761
                
                
                
                4,553,439Total
      interest income
                
                
                59,363,795
                
                
                
                70,078,248
                
                
                
                67,751,554Interest
      expenseInterest
      on deposits
                
                
                21,095,044
                
                
                
                27,499,996
                
                
                
                23,858,628Interest
      on borrowings
                
                
                1,563,978
                
                
                
                771,976
                
                
                
                932,559Interest
      on junior subordinated debentures
                
                
                657,576
                
                
                
                839,110
                
                
                
                815,331Total
      interest expense
                
                
                23,316,598
                
                
                
                29,111,082
                
                
                
                25,606,518Net
      interest income before provision for credit losses
                
                
                36,047,197
                
                
                
                40,967,166
                
                
                
                42,145,036Provision
      for credit losses
                
                
                4,043,600
                
                
                
                350,000
                
                
                
                932,878Net
      interest income
                
                
                32,003,597
                
                
                
                40,617,166
                
                
                
                41,212,158Other
      incomeFees
      and service charges
                
                
                7,750,195
                
                
                
                7,341,240
                
                
                
                6,723,391Loan
      servicing fees
                
                
                658,073
                
                
                
                651,358
                
                
                
                666,032Gain
      (loss) on sale of real estate, net
                
                
                (80,542
                )
                
                
                49,644
                
                
                
                10,237Gain
      on sale of mortgage loans
                
                
                586,571
                
                
                
                519,361
                
                
                
                329,743Other
      income
                
                
                1,169,263
                
                
                
                1,575,171
                
                
                
                1,529,644Total
      other income
                
                
                10,083,560
                
                
                
                10,136,774
                
                
                
                9,259,047General
      and administrative expensesCompensation
      and fringe benefits
                
                
                13,750,085
                
                
                
                13,973,012
                
                
                
                13,582,647Federal
      insurance premiums
                
                
                280,372
                
                
                
                94,349
                
                
                
                95,012Premises
      and equipment
                
                
                1,969,006
                
                
                
                1,938,555
                
                
                
                1,776,903Advertising
                
                
                112,758
                
                
                
                125,490
                
                
                
                207,246Payroll
      and other taxes
                
                
                1,246,743
                
                
                
                1,308,248
                
                
                
                1,305,008Data
      processing
                
                
                2,630,821
                
                
                
                2,524,983
                
                
                
                2,362,751Amortization
      of intangible assets
                
                
                434,260
                
                
                
                394,508
                
                
                
                375,463Other
                
                
                3,740,652
                
                
                
                2,551,831
                
                
                
                2,502,015Total
      general and administrative expenses
                
                
                24,164,697
                
                
                
                22,910,976
                
                
                
                22,207,045Income
      before income taxes
                
                
                17,922,460
                
                
                
                27,842,964
                
                
                
                28,264,160Income
      taxes
                
                
                6,934,640
                
                
                
                10,839,737
                
                
                
                11,071,804NET
      INCOME
                
                
                10,987,820
                
                
                
                17,003,227
                
                
                
                17,192,356Other
      comprehensive income (loss), net of taxes
                
                
                802,984
                
                
                
                955,829
                
                
                
                (208,408
                )Comprehensive
      income
                
                $
                11,790,804
                
                
                $
                17,959,056
                
                
                $
                16,983,948Net
      income per common shareBasic
                
                $
                1.13
                
                
                $
                1.71
                
                
                $
                1.77Diluted
                
                $
                1.12
                
                
                $
                1.70
                
                
                $
                1.72








F-18


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 Years
Ended December 31, 2008, 2007 and 2006


Common
                    stock
                  
                  
                  Additional
                    paid-in
                    capital
                  
                  
                  Retained
                    earnings,
                    substantially
                    restricted
                  
                  
                  Treasury
                    stock
                  
                  
                  Accumulated
                    other
                    comprehensive
                    income
                    (loss), net
                  
                  
                  TotalBalance, December
      31, 2005
                  
                  $
                  63,395
                  
                  
                  $
                  37,624,894
                  
                  
                  $
                  59,661,079
                  
                  
                  $
                  (28,787,979
                  )
                  
                  $
                  (370,917
                  )
                  
                  $
                  68,190,472Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  17,192,356
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  17,192,356Other
      comprehensive loss, net
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (208,408
                  )
                  
                  
                  (208,408
                  )Exercise
      of stock options
                  
                  
                  3,706
                  
                  
                  
                  (5,963,302
                  )
                  
                  
                  -
                  
                  
                  
                  6,605,460
                  
                  
                  
                  -
                  
                  
                  
                  645,864Tax
      benefit, stock options exercised
                  
                  
                  -
                  
                  
                  
                  3,965,214
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  3,965,214Shares
      traded to exercise options
                  
                  
                  (1,517
                  )
                  
                  
                  2,412,280
                  
                  
                  
                  -
                  
                  
                  
                  (6,054,715
                  )
                  
                  
                  -
                  
                  
                  
                  (3,643,952
                  )Acquisition
      of treasury shares
                  
                  
                  (245
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (867,660
                  )
                  
                  
                  -
                  
                  
                  
                  (867,905
                  )Stock
      based compensation
                  
                  
                  -
                  
                  
                  
                  126,450
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  126,450Dividends
      ($.68 per share)
                  
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  (6,594,848
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (6,594,848
                  )3-for-2
      stock split
                  
                  
                  32,542
                  
                  
                  
                  -
                  
                  
                  
                  (41,207
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (8,665
                  )Balance,
      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 loss, 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
                  
                  
                  $
                  87,821,025






F-19





FIRST SOUTH BANCORP, INC. ANDSUBSIDIARY
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 Years
Ended December 31, 2008, 2007 and 2006





2008
                      
                      
                      2007
                      
                      
                      2006Operating
      activitiesNet
      income
                      
                      $
                      10,987,820
                      
                      
                      $
                      17,003,227
                      
                      
                      $
                      17,192,356Adjustments
      to reconcile net income to net cash provided by (used in) operating
      activitiesProvision
      for credit losses
                      
                      
                      4,043,600
                      
                      
                      
                      350,000
                      
                      
                      
                      932,878Depreciation
                      
                      
                      879,832
                      
                      
                      
                      813,510
                      
                      
                      
                      843,017Amortization
      of intangibles
                      
                      
                      434,260
                      
                      
                      
                      394,508
                      
                      
                      
                      375,463Accretion
      of discounts on securities, net
                      
                      
                      7,383
                      
                      
                      
                      (12,849
                      )
                      
                      
                      59,769Deferred
      income taxes
                      
                      
                      (862,742
                      )
                      
                      
                      (438,860
                      )
                      
                      
                      (201,747
                      )(Gain)
      loss on disposal of premises and equipmentand
      real estate owned
                      
                      
                      82,082
                      
                      
                      
                      (206,891
                      )
                      
                      
                      (157,856
                      )Gain
      on loans held for sale and mortgage-backed
      securities
                      
                      
                      (684,108
                      )
                      
                      
                      (519,361
                      )
                      
                      
                      (329,743
                      )Stock
      based compensation expense
                      
                      
                      37,133
                      
                      
                      
                      83,764
                      
                      
                      
                      126,450Originations
      of loans held for sale, net
                      
                      
                      (38,549,148
                      )
                      
                      
                      (23,668,607
                      )
                      
                      
                      (32,791,666
                      )Proceeds
      from sale of loans held for sale
                      
                      
                      37,686,012
                      
                      
                      
                      35,374,932
                      
                      
                      
                      1,187,887Other
      operating activities
                      
                      
                      3,011,045
                      
                      
                      
                      (459,284
                      )
                      
                      
                      (1,936,077
                      )Net
      cash provided by (used in) operating activities
                      
                      
                      17,073,169
                      
                      
                      
                      28,714,089
                      
                      
                      
                      (14,699,269
                      )Investing
      activitiesProceeds
      from maturities of investment securities available for
sale
                      
                      
                      13,000,000
                      
                      
                      
                      9,000,000
                      
                      
                      
                      10,050,000Purchases
      of investment securities available for sale
                      
                      
                      -
                      
                      
                      
                      (500,000
                      )
                      
                      
                      (25,000,000
                      )Proceeds
      from principal repayments and sales of mortgage-backed securities
      available for sale
                      
                      
                      10,155,010
                      
                      
                      
                      4,579,831
                      
                      
                      
                      2,682,350Proceeds
      from principal repayments of mortgage-backed securities held for
      investment
                      
                      
                      459,541
                      
                      
                      
                      370,778
                      
                      
                      
                      400,770Originations
      of loans held for investment, net of principal repayments
                      
                      
                      3,476,254
                      
                      
                      
                      (23,651,034
                      )
                      
                      
                      (39,762,587
                      )Proceeds
      from disposal of premises and equipment and real estate
    owned
                      
                      
                      3,883,475
                      
                      
                      
                      1,192,808
                      
                      
                      
                      847,830Purchases
      of FHLB stock
                      
                      
                      (448,500
                      )
                      
                      
                      (1,276,800
                      )
                      
                      
                      (244,100
                      )Purchases
      of premises and equipment
                      
                      
                      (497,902
                      )
                      
                      
                      (1,707,363
                      )
                      
                      
                      (1,094,382
                      )Net
      cash provided by (used in) investing activities
                      
                      
                      30,027,878
                      
                      
                      
                      (11,991,780
                      )
                      
                      
                      (52,120,119
                      )Financing
      activitiesNet
      increase (decrease) in deposit accounts
                      
                      
                      (44,942,787
                      )
                      
                      
                      (38,818,898
                      )
                      
                      
                      66,435,416Net
      increase in FHLB borrowings
                      
                      
                      10,000,000
                      
                      
                      
                      29,000,000
                      
                      
                      
                      500,000Purchase
      of treasury shares
                      
                      
                      (2,845,412
                      )
                      
                      
                      (6,722,276
                      )
                      
                      
                      (867,905
                      )Proceeds
      from exercise of stock options, net of tax benefit
                      
                      
                      602,930
                      
                      
                      
                      3,459,780
                      
                      
                      
                      967,126Cash
      paid for dividends and fractional shares
                      
                      
                      (7,715,777
                      )
                      
                      
                      (7,342,722
                      )
                      
                      
                      (6,207,440
                      )Net
      change in repurchase agreements
                      
                      
                      491,071
                      
                      
                      
                      1,927,474
                      
                      
                      
                      (1,147,581
                      )Net
      cash provided by (used in) financing activities
                      
                      
                      (44,409,975
                      )
                      
                      
                      (18,496,642
                      )
                      
                      
                      59,679,616Increase
      (decrease) in cash and cash equivalents
                      
                      
                      2,691,072
                      
                      
                      
                      (1,774,333
                      )
                      
                      
                      (7,139,772
                      )Cash
      and cash equivalents, beginning of year
                      
                      
                      24,029,287
                      
                      
                      
                      25,803,620
                      
                      
                      
                      32,943,392Cash
      and cash equivalents, end of year
                      
                      $
                      26,720,359
                      
                      
                      $
                      24,029,287
                      
                      
                      $
                      25,803,620







F-20


FIRST
SOUTH BANCORP, INC. AND SUBSIDIARY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 As
of And For The Years Ended December 31, 2008, 2007 and 2006





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 State 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.


F-21


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 $8.2 million of loans classified as impaired at December 31, 2008. The
allowance for loan losses included $1.6 million specifically provided for these
impaired loans as of December 31, 2008.  Average impaired loans were
$5.8 million for the year ended December 31, 2008.  Interest income
recognized on impaired loans for the year ended December 31, 2008 was
$516,000.  At December 31, 2007, there were no 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.


F-22





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 $402,820, $363,068
and $344,023 for prepayments during the years ended December 31, 2008, 2007 and
2006, respectively. There were no impairments recognized during the years ended
December 31, 2008, 2007 and 2006.





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,
2008, 2007 and 2006 were $772,000, $0 and $0, respectively.


F-23





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





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, 2008 and 2007, the Bank
owned 36,586 and 32,101 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, 2008.





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, 2008, 2007 and
2006, 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 (as defined in
SFAS No. 142) 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





The
Company reports income taxes in accordance with Statement of Financial
Accounting Standards No. 109 ("SFAS No. 109"), “Accounting for Income Taxes,”
which requires the recognition of deferred tax assets and liabilities for the
temporary difference between financial statement and tax basis of the Company's
assets and liabilities using the enacted tax rates in effect in the years in
which the differences are expected to reverse. Valuation allowances are provided
if based upon the weight of available evidence, it is more likely than not that
some or all of the deferred tax assets will not be realized.  The
Company has adopted FASB Interpretation No. 48 (“FIN 48”), “Accounting for
Uncertainty in Income Taxes” and has assessed if it had any significant
uncertain tax positions as of December 31, 2008 and December 31, 2007 and
determined there were none.  Accordingly, no reserve for uncertain tax
positions was recorded





ADVERTISING





Advertising
costs are expensed as incurred. For the years ended December 31, 2008, 2007 and
2006, the Company incurred advertising expense totaling $112,757, $125,490 and
$207,246, respectively.





COMPREHENSIVE
INCOME





The
Company's other comprehensive income 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, 2008, 2007 and 2006
is as follows:





Years ended December 31,2008
                
                
                2007
                
                
                2006Unrealized
      gains (losses)on securities available for sale
                
                $
                1,327,246
                
                
                $
                1,565,079
                
                
                $
                (357,109
                )Income
      tax benefit (expense)
                
                
                (524,262
                )
                
                
                (609,250
                )
                
                
                148,701Other
      comprehensive income (loss), net
                
                $
                802,984
                
                
                $
                955,829
                
                
                $
                (208,408
                )


F-24





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





SEGMENT
INFORMATION





The
Company follows the provisions of SFAS No. 131, “Disclosure About Segments of an
Enterprise and Related Information,” which specifies guidelines for determining
an entity's 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.





STOCK
SPLIT





On May
25, 2006, the Company paid a three-for-two stock split, in the form of a 50%
stock dividend, to stockholders of record as of May 4,
2006.  Stockholders received one additional share of common stock for
every two shares held on the record date.  All prior period share and
per share data have been adjusted for the split.





NEW
ACCOUNTING PRONOUNCEMENTS





In
September 2006, the Financial Accounting Standards Board (the “FASB”) issued
Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”),
“Fair Value Measurements”.  This Statement defines fair value,
establishes a framework for measuring fair value in generally accepted
accounting principles (GAAP), and expands disclosures about fair value
instruments.  This Statement applies under other accounting
pronouncements that require or permit fair value measurements, the FASB having
previously concluded in those accounting pronouncements that fair value is the
relevant measure attribute.  Accordingly, this statement does not
require any new fair value measurements.  However, for some entities,
it will change current practice.  It is effective for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal
years. The Company adopted SFAS No. 157 on January 1, 2008, with no material
impact on its consolidated financial statements.





In
February 2007, the FASB issued Statement of Financial Accounting Standards No.
159 (“SFAS No. 159”), “The Fair Value Option for Financial Assets and
Financial Liabilities – Including an Amendment of FASB Statement No.
115”.  This Statement permits entities to choose measuring many
financial instruments and certain other items at fair value.  The
objective is to improve financial reporting by providing entities with the
opportunity to mitigate volatility in reported earnings caused by measuring
related assets and liabilities differently without applying complex hedge
accounting provisions.  This Statement is expected to expand the use
of fair value measurement, which is consistent with the FASB’s long-term
measurement objectives for accounting for financial instruments.  It
is effective for fiscal years beginning after November 15,
2007.  The Company adopted SFAS No. 159 on January 1, 2008; however,
the Company has not elected to measure eligible items at fair value, and
continues to evaluate the future impact it may have on its consolidated
financial statements.





In May
2008, the FASB issued Statement of Financial Accounting Standards No. 162
(“SFAS No. 162”), “The Hierarchy of Generally Accepted Accounting
Principles”.  This Statement identifies the sources of accounting
principles and the framework for selecting the principles to be used in the
preparation of financial statements of non-governmental entities that are
presented in conformity with generally accepted accounting principles (GAAP) in
the United States (the GAAP hierarchy).  The FASB does not expect that
this Statement will result in a change in practice.  It is effective
60 days following the SEC’s approval of the Public Company Accounting Oversight
Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity
With Generally Accepted Accounting Principles”. The Company is currently
evaluating the impact SFAS No. 162 may have on its consolidated financial
statements.





In
February 2008, the FASB issued FASB Staff Position No. 157-1 (“FSP No. FAS
157-1”), “The Application of FASB Statement No. 157 to FASB Statement No. 13 and
Other Accounting Pronouncements that Address Fair Value Measurements for
Purposes of Lease Classification or Measurement Under Statement
13”.  This FSP amends SFAS No. 157, “Fair Value Measurements”, to
exclude SFAS No. 13, “Accounting for Leases”, and other accounting
pronouncements that address fair value measurements for purposes of lease
classification or measurement under SFAS No. 13.  However, this scope
exception does not apply to assets acquired and liabilities assumed in a
business combination that are required to be measured at fair value under SFAS
No. 141, “Business Combinations”, or SFAS No. 141 (revised 2007), “Business
Combinations”, regardless of whether those assets and liabilities are related to
leases.


F-25





1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)





NEW
ACCOUNTING PRONOUNCEMENTS (Continued)





This FSP
shall be effective upon the initial adoption of SFAS No. 157.  The
Company adopted SFAS No. 157 on January 1, 2008, with no material impact on its
consolidated financial statements, and will apply this FSP in a consistent
manner.





In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2 (“FSP No. FAS
157-2”), “Effective Date of FASB Statement No. 157”.  This FSP delays
the effective date of SFAS No. 157, “Fair Value Measurements”, for non-financial
assets and non-financial liabilities, except for items that are recognized or
disclosed at fair value in financial statements on a recurring basis (at lease
annually).  The delay is intended to allow the FASB and constituents
additional time to consider the effect of various implementation issues that
have arisen, or that may arise, from the application of SFAS No.
157.   This FSP defers the effective date of SFAS No. 157 to
fiscal years beginning after November 15, 2008, and interim periods within those
fiscal years for items within the scope of this FSP.  The Company
adopted SFAS No. 157 on January 1, 2008, with no material impact on its
consolidated financial statements.





In
February 2008, the FASB issued FASB Staff Position No. FAS 140-3 (“FSP No. FAS
140-3”), “Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions”.  SFAS No. 140, “Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities”, provides accounting and
reporting standards for transfers of financial assets, but it does not directly
address the repurchase financing transaction.  The objective of this
FSP is to provide guidance on accounting for a transfer of a financial asset and
a repurchase financing.  It is effective for fiscal years beginning
after November 15, 2008.  The Company is currently evaluating the
impact this FSP may have on its consolidated financial statements.





In June
2008, the FASB issued FASB Staff Position No. EITF 03-6-1 (“FSP No. EITF
03-6-1”), “Determining Whether Instruments Granted in Share-Based Payment
Transactions are Participating Securities”. This FSP addresses whether
instruments granted in share-based payment transactions are participating
securities prior to vesting and, therefore, need to be included in the earnings
allocation in computing earnings per share (EPS) under the two-class method
described in paragraphs 60 and 61 of SFAS No. 128, “Earnings per
Share”.  The guidance of this FSP applies to the calculation of EPS
under SFAS No. 128 for share-based awards with rights to dividends and dividend
equivalents.  It is effective for fiscal years and interim periods
beginning after December 15, 2008.  The Company is currently
evaluating the impact this FSP may have on its consolidated financial
statements.





In
October 2008, the FASB issued FASB Staff Position No. FAS 157-3 (“FAS 157-3”),
“Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active”.  This FSP clarifies the FASB Statement No. 157 for a
market that is not active the use of a reporting entity’s own assumptions about
future cash flows and appropriately risk-adjusted discount rates is acceptable
when relevant observable inputs are not available.  Broker (or pricing
service) quotes may be an appropriate input when measuring fair
value.  However, less reliance should be put on quotes that do not
reflect market transactions but rather are derived from broker
models.  This FSP shall be effective upon issuance including prior
periods for which financial statements have not been issued. The Company is
currently evaluating the impact this FSP may have on its consolidated financial
statements.





In
November 2007, the SEC issued Staff Accounting Bulletin No. 109, “Miscellaneous
Accounting – Written Loan Commitments Recorded at Fair Value through Earnings”
(“SAB 109”).  SAB 109 addresses written loan commitments that are
accounted for at fair value through earnings under generally accepted accounting
principles.  This Bulletin supersedes SAB 105, “Accounting for
Derivative Instruments and Hedging Activities” and concludes that expected net
future cash flows related to the associated servicing of the loan should be
included in the measurement of all written loan commitments that are accounted
for at fair value through earnings.  SAB 109 retains that staff view
and broadens its application to all written loan commitments that are accounted
for as fair value through earnings. The SEC expects registrants to apply the
views in Question 1 of SAB 109 on a prospective basis to derivative loan
commitments issued or modified in fiscal quarters beginning after December 15,
2008.  The Company adopted SAB 109 on January 1, 2008, with no
material impact on its consolidated financial statements.


F-26


1.
BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)
 
 NEW
ACCOUNTING PRONOUNCEMENTS (Continued)
 
 In
December 2007, the SEC issued Staff Accounting Bulletin No. 110, “Share-Based
Payment – Certain Assumptions Used in Valuation Methods – Expected Term” (“SAB
110”).  SAB 110 provides guidance on developing an estimated term of
“plain vanilla” share options in accordance with SFAS No. 123R, “Share-Based
Payment”.  Because detailed external information about employee
exercise behavior may not be readily available, the SEC staff will continue to
accept, under certain circumstances, the use of the simplified method beyond
December 31, 2007.  The Company adopted SAB 110 on January 1, 2008
with no material effect on its consolidated financial statements.
 
 From time
to time, the FASB issues exposure drafts for proposed statements of financial
accounting standards. Such exposure drafts are subject to comment from the
public, to revisions by the FASB and to final issuance by the FASB as statements
of financial accounting standards. Management considers the effect of the
proposed statements on the consolidated financial statements of the Company and
monitors the status of changes to and proposed effective dates of exposure
drafts.
 
 2.
INVESTMENT SECURITIES
 
 Investment
securities at December 31, 2008 and 2007 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, 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
                  )
                  
                  $
                  36,563,646December
      31, 2007:U.S.
      Treasury and Agency Notes
                  
                  $
                  47,944,142
                  
                  
                  $
                  720,303
                  
                  
                  $
                  (13,496
                  )
                  
                  $
                  48,650,949Triangle
      Capital Corporation
                  
                  
                  500,000
                  
                  
                  
                  -
                  
                  
                  
                  (86,671
                  )
                  
                  
                  413,329$
                  48,444,142
                  
                  
                  $
                  720,303
                  
                  
                  $
                  (100,167
                  )
                  
                  $
                  49,064,278
 
 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, 2008, the TCAP equity securities owned by the Company had a market
value of $343,642. Unrealized loss on Triangle Capital Corporation equity
security is considered by management to be temporary.
 
 The
following table summarizes U.S. Treasury and Agency Notes unrealized losses and
fair value, aggregated by length of time that individual securities have been in
a continuous unrealized loss position at December 31, 2007. There were no U.S.
Treasury and Agency Notes in an unrealized loss position at December 31,
2008.
 
 2007Less
      Than 12 Months
                  
                  
                  12
      Months or More
                  
                  
                  TotalFair
                    value
                  
                  
                  Unrealized
                    losses
                  
                  
                  Fair
                    value
                  
                  
                  Unrealized
                    losses
                  
                  
                  Fair
                    losses
                  
                  
                  Unrealized
                    lossesSecurities
      available for sale:U.S.
      Treasury and Agency Notes
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  7,983,712
                  
                  
                  $
                  (13,496
                  )
                  
                  $
                  7,983,712
                  
                  
                  $
                  (13,496
                  )
  F-27
  2.
INVESTMENT SECURITIES (Continued)
 
 U.S.
Treasury and Agency notes at December 31, 2008 are contractually scheduled to
mature as follows:
 
 EstimatedAmortized
                    
                    
                    marketcost
                    
                    
                    valueDue
      within one year
                    
                    $
                    20,017,015
                    
                    
                    $
                    20,490,916Due
      after one year through five years
                    
                    
                    14,919,744
                    
                    
                    
                    15,729,088Total
                    
                    $
                    34,936,759
                    
                    
                    $
                    36,220,004
 
 There
were no sales of U.S. Treasury and Agency Notes during the years ended December
31, 2008, 2007 and 2006.
 U.S.
Treasury and Agency Notes with an amortized cost of approximately $12.8 million
and $18.8 million were pledged to secure deposits from public entities and
repurchase agreements at December 31, 2008 and 2007, respectively.
 
 3.
MORTGAGE-BACKED SECURITIES
 
 Mortgage-backed
securities at December 31, 2008 and 2007 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, 2008:FHLMC
      PCs, maturing from years 2009 to 2038
                  
                  $
                  31,167,477
                  
                  
                  $
                  827,680
                  
                  
                  $
                  -
                  
                  
                  $
                  31,995,157December
      31, 2007:FHLMC
      PCs, maturing from years 2008 to 2037
                  
                  $
                  37,825,879
                  
                  
                  $
                  305,477
                  
                  
                  $
                  (303,292
                  )
                  
                  $
                  37,828,064
 
 Mortgage-backed
securities at December 31, 2008 and 2007 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, 2008:FHLMC
      PCs, maturing during 2013
                  
                  $
                  832,221
                  
                  
                  $
                  25,882
                  
                  
                  $
                  -
                  
                  
                  $
                  858,103December
      31, 2007:FHLMC
      PCs, maturing during 2013
                  
                  $
                  1,291,762
                  
                  
                  $
                  -
                  
                  
                  $
                  (20,591
                  )
                  
                  $
                  1,271,171
 
 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, 2007. There were no
mortgage-backed securites in an unrealized loss position at December 31,
2008.
 
 2007Less
      Than 12 Months
                  
                  
                  12
      Months or More
                  
                  
                  TotalFair
                    value
                  
                  
                  Unrealized
                    losses
                  
                  
                  Fair
                    value
                  
                  
                  Unrealized
                    losses
                  
                  
                  Fair
                    losses
                  
                  
                  Unrealized
                    lossesSecurities
      available for sale:FHLMC
      PCs
                  
                  $
                  1,418,557
                  
                  
                  $
                  (2,900
                  )
                  
                  $
                  18,997,231
                  
                  
                  $
                  (300,392
                  )
                  
                  $
                  20,415,788
                  
                  
                  $
                  (303,292
                  )Securities
      held for investment:FHLMC
      PCs
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  1,271,171
                  
                  
                  $
                  (20,591
                  )
                  
                  $
                  1,271,171
                  
                  
                  $
                  (20,591
                  )
  F-28
  3.
MORTGAGE-BACKED SECURITIES (Continued)
 
 Mortgage-backed
securities, classified as available for sale or held for investment, at December
31, 2008 are contractually scheduled to mature as follows:
  EstimatedAmortized
                  
                  
                  marketcost
                  
                  
                  valueDue
      one year or less
                  
                  $
                  399
                  
                  
                  $
                  413Due
      after one year through five years
                  
                  
                  1,418,253
                  
                  
                  
                  1,466,198Due
      after five years through ten years
                  
                  
                  1,157,856
                  
                  
                  
                  1,201,337Due
      after ten years
                  
                  
                  29,423,190
                  
                  
                  
                  30,185,312Total
                  
                  $
                  31,999,698
                  
                  
                  $
                  32,853,260
 
 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 $4,022,495, $0
and $0 were sold during the years ended December 31, 2008, 2007 and 2006,
respectively. Mortgage-backed securities with an amortized cost of $318,321 and
$446,918 were pledged as collateral for treasury tax and loan deposits at
December 31, 2008 and 2007, respectively.
 
 4.
LOANS RECEIVABLE
 
 Loans
receivable at December 31, 2008 and 2007 are summarized as follows:
 
 2008
                  
                  
                  2007Mortgage
      loans
                  
                  $
                  46,990,010
                  
                  
                  $
                  51,189,747Consumer
      loans
                  
                  
                  101,808,252
                  
                  
                  
                  101,693,778Commercial
      loans
                  
                  
                  597,012,445
                  
                  
                  
                  609,970,239Lease
      receivables
                  
                  
                  11,560,539
                  
                  
                  
                  13,101,150Total
                  
                  
                  757,371,246
                  
                  
                  
                  775,954,914Less:  Allowance
      for loan losses
                  
                  
                  (11,617,706
                  )
                  
                  
                  (9,486,479
                  )Deferred loan
      fees, net
                  
                  
                  (1,022,243
                  )
                  
                  
                  (1,385,530
                  )Loans
      receivable, net
                  
                  $
                  744,731,297
                  
                  
                  $
                  765,082,905
 
 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, 2008, 2007, and 2006 the Bank exchanged loans with
outstanding principal balances of $3,399,071, $6,873,490 and $17,203,225,
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, 2008
and 2007 are fixed rate mortgage loans with an estimated market value of
approximately $5,781,287 and $7,752,968, respectively. Net gains on sales of
loans receivable held for sale amounted to $586,571, $519,361and $329,743 for
the years ended December 31, 2008, 2007 and 2006, respectively.
  F-29
  4.
LOANS RECEIVABLE (Continued)
 
 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, 2008,
2007 and 2006, is summarized as follows:
 
 Allowance
      for
                    Loan
      and Lease
                    Losses
                  
                  
                  Allowance
      for
                    Unfunded
                    Commitments
                  
                  
                  Allowance
      for
                    Credit
      LossesBalance
      at December 31, 2005
                  
                  $
                  8,113,416
                  
                  
                  $
                  1,108,889
                  
                  
                  $
                  9,222,305Provisions
      for credit losses
                  
                  
                  1,276,827
                  
                  
                  
                  (343,949
                  )
                  
                  
                  932,878Loans
      charged off
                  
                  
                  (342,094
                  )
                  
                  
                  -
                  
                  
                  
                  (342,094
                  )Recoveries
                  
                  
                  109,448
                  
                  
                  
                  -
                  
                  
                  
                  109,448Balance
      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
                  
                  
                  $
                  11,957,701
 
 Following
is a summary of the principal balances of loans on nonaccrual status and loans
past due over ninety days:
 
 December
      31,2008
                      
                      2007Loans
      contractually past due over 90 days and/or on nonaccrual
      status:Mortgage
      residential
                      
                      $
                      1,211,334
                      
                      
                      $
                      798,072Consumer
      and commercial
                      
                      
                      14,620,731
                      
                      
                      
                      6,757,386Total
                      
                      $
                      15,832,065
                      
                      
                      $
                      7,555,458
 
 For the
years ended December 31, 2008, 2007 and 2006, interest income of $624,265,
$505,990 and $143,407, respectively, was not recorded related to loans accounted
for on a nonaccrual basis.
 
 5.
PREMISES AND EQUIPMENT
 
 Premises
and equipment consist of the following:
  December
      31,2008
                  
                  
                  2007Land
                  
                  $
                  3,102,730
                  
                  
                  $
                  3,102,730Office
      buildings and improvements
                  
                  
                  7,699,008
                  
                  
                  
                  7,481,953Furniture,
      fixtures and equipment
                  
                  
                  5,020,744
                  
                  
                  
                  4,927,893Vehicles
                  
                  
                  537,312
                  
                  
                  
                  479,797Construction
      in process
                  
                  
                  -
                  
                  
                  
                  27,85716,359,794
                  
                  
                  
                  16,020,230Less
      accumulated depreciation
                  
                  
                  7,309,865
                  
                  
                  
                  6,586,831Total
                  
                  $
                  9,049,929
                  
                  
                  $
                  9,433,399
 
 The
Company leases certain branch facilities and equipment under separate agreements
that expire at various dates through December 31, 2013. Future rentals under
these leases are as follows:
 
 2009
                    
                    $
                    539,8822010
                    
                    
                    403,4812011
                    
                    
                    321,2232012
                    
                    
                    308,1912013
                    
                    
                    209,653Thereafter
                    
                    
                    -Total
                    
                    $
                    1,782,430
  F-30
  5.
PREMISES AND EQUIPMENT (Continued)
 
 Rental
expense of $601,510, $541,180 and $444,412 during the years ended December 31,
2008, 2007 and 2006, respectively, is included in premises and equipment expense
on the accompanying consolidated statements of operations.
 
 6.
DEPOSITS
 
 At
December 31, 2008, the scheduled maturities of time deposits were as
follows:
 
 2009
                    
                    $
                    404,953,0152010
                    
                    
                    46,118,2832011
                    
                    
                    12,371,1912012
                    
                    
                    2,842,3672013
                    
                    
                    220,517Thereafter
                    
                    
                    -Total
      time deposits
                    
                    $
                    466,505,373
 
 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. Expenses of the plan for unfunded liability, withdrawal fees,
administrative fees and PBGC premiums for the years ended December 31, 2008,
2007 and 2006 were $0, $0 and $9,470, respectively.
 
 The
Company also participates in a defined contribution plan which covers
substantially all employees. During the years ended December 31, 2008, 2007 and
2006, 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.
 
 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, 2008,
2007 and 2006 were $351,394, $293,475 and $354,235, 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,
2008, 2007 and 2006 was $408,303, $449,464 and $471,509, 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
$3,175,291 at December 31, 2008 and is included in other liabilities in the
accompanying consolidated statements of financial condition.
 
 8.
STOCK-BASED COMPENSATION
 
 The
Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS
No. 123R”), issued by the Financial Accounting Standards Board (the
“FASB”), effective January 1, 2006. SFAS No. 123R requires the cost of
employee services received in exchange for an award of equity instruments to be
recognized in the financial statements over the period the employee is required
to perform the services in exchange for the award (presumptively the vesting
period). SFAS No. 123R also requires measurement of the cost of employee
services received in exchange for an award based on the grant date fair value of
the award.
 
 At
December 31, 2008, the Company had two stock-based compensation
plans.  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 the 1997 Plan.  At
December 31, 2008, the 1997 Plan had 161,295 granted unexercised
shares.
  F-31
  8.
STOCK-BASED COMPENSATION (Continued)
 
 On May
22, 2008, the Shareholders of the Company approved the 2008 Plan for a term of
ten years.  At December 31, 2008, the 2008 Plan includes 11,000
granted unexercised shares and 947,000 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, 2008
and 2007 was $2.36 and $3.70, 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, 2008, 2007 and 2006:
 
 December
      31,Year Ended:
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006Dividend
      growth rate
                    
                    
                    11.8
                    %
                    
                    
                    17
                    %
                    
                    
                    17
                    %Expected
      volatility
                    
                    
                    24.0
                    %
                    
                    
                    22.6
                    %
                    
                    
                    22.3
                    %Average
      risk-free interest rates
                    
                    
                    3.34
                    %
                    
                    
                    3.95
                    %
                    
                    
                    4.88
                    %Expected
      lives
                    
                    6
      years
                    
                    
                    6
      years
                    
                    
                    6
      years
 
 A summary
of option activity under the Plans as of December 31, 2008 and 2007, and
changes during the years then ended is presented below:
 
 Options
                          Available
                        
                        
                        Options
                          Outstanding
                        
                        
                        Price
                        
                        
                        Aggregate
                          Intrinsic
                          ValueOutstanding
      at December 31, 2006
                        
                        
                        988,277
                        
                        
                        
                        538,374
                        
                        
                        $
                        9.65
                        
                        
                        $
                        11,975,810Granted
                        
                        
                        (28,750
                        )
                        
                        
                        28,750
                        
                        
                        
                        24.39Forfeited
                        
                        
                        8,125
                        
                        
                        
                        (8,125
                        )
                        
                        
                        19.37Exercised
                        
                        
                        -
                        
                        
                        
                        (303,080
                        )
                        
                        
                        7.19Outstanding
      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
                        )
 
 The
compensation costs recorded under SFAS No. 123R that have been charged against
income for these plans were $37,132 and $83,763 for the years ended December 31,
2008 and 2007, respectively. Total unrecognized compensation cost on granted
unexercised shares was $115,129 at December 31, 2008, compared to $167,665 at
December 31, 2007.  That cost is expected to be recognized over the
next four years.
 
 The total
income tax benefit recognized for stock-based compensation costs were $452,317
and $2,430,435 for the years ended December 31, 2008 and 2007,
respectively.
 
 The total
intrinsic value of options exercised during the years ended December 31, 2008
and 2007 was $1,342,854 and $7,083,625, respectively.
  F-32
  8.
STOCK-BASED COMPENSATION (Continued)
 
 The
following table summarizes additional information about the Company’s
outstanding options and exercisable options as of December 31, 2008, 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
      – 10.37
                  
                  
                  40,283
                  
                  
                  
                  2.35
                  
                  
                  $
                  8.14
                  
                  
                  
                  40,283
                  
                  
                  $
                  8.14$14.97
      – 16.61
                  
                  
                  36,562
                  
                  
                  
                  4.08
                  
                  
                  
                  16.10
                  
                  
                  
                  36,562
                  
                  
                  
                  16.10$16.77
      – 25.22
                  
                  
                  77,200
                  
                  
                  
                  5.82
                  
                  
                  
                  20.41
                  
                  
                  
                  44,075
                  
                  
                  
                  19.99$26.17
      – 33.30
                  
                  
                  18,250
                  
                  
                  
                  7.46
                  
                  
                  
                  28.85
                  
                  
                  
                  8,100
                  
                  
                  
                  29.56172,295
                  
                  
                  
                  3.23
                  
                  
                  
                  17.52
                  
                  
                  
                  129,020
                  
                  
                  
                  15.79
 
 A summary
of nonvested option shares as of December 31, 2008 and 2007, and changes
during the years ended December 31, 2008 and 2007 is presented
below:
 
 Year
      Ended:
                  
                  December
      31, 2008
                  
                  
                  December
      31, 2007Shares
                  
                  
                  Price
                  
                  
                  Shares
                  
                  
                  PriceNonvested
      at beginning of year
                  
                  
                  53,975
                  
                  
                  $
                  24.38
                  
                  
                  
                  53,250
                  
                  
                  $
                  22.89Granted
                  
                  
                  24,000
                  
                  
                  
                  19.85
                  
                  
                  
                  28,750
                  
                  
                  
                  24.39Forfeited
                  
                  
                  (11,500
                  )
                  
                  
                  25.78
                  
                  
                  
                  (3,250
                  )
                  
                  
                  24.97Vested
                  
                  
                  (23,200
                  )
                  
                  
                  22.16
                  
                  
                  
                  (24,775
                  )
                  
                  
                  21.11Nonvested
      at end of year
                  
                  
                  43,275
                  
                  
                  
                  22.68
                  
                  
                  
                  53,975
                  
                  
                  
                  24.38
 
 The
following table reflects the impact of adopting SFAS 123R by reducing income
before income taxes, net income, basic earnings per share and diluted earnings
per share for the years ended December 31, 2008, 2007 and 2006:
 
 Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Reduced
      net income before income taxes
                  
                  $
                  37,132
                  
                  
                  $
                  83,763
                  
                  
                  $
                  126,450Reduced
      net income
                  
                  
                  36,228
                  
                  
                  
                  76,843
                  
                  
                  
                  115,038Reduced
      basic earnings per share
                  
                  
                  .00
                  
                  
                  
                  .01
                  
                  
                  
                  .01Reduced
      diluted earnings per share
                  
                  
                  .01
                  
                  
                  
                  .00
                  
                  
                  
                  .01
 
 9.
BORROWED MONEY
 
 Borrowed
money represents advances from the FHLB and repurchase agreements. Outstanding
FHLB advances at December 31, 2008 and 2007 totaled $45.0 million and $35.0
million, respectively and had a weighted average fixed rate of 3.01% at December
31, 2008 and a weighted average floating rate of 4.40% at December 31,
2007.  At December 31, 2008, the FHLB advances consisted of, $10.0
million with a scheduled maturity date of July 29, 2009; $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. Outstanding FHLB at December 31, 2007 had a
scheduled maturity date of January 3, 2008.
 
 At
December 31, 2008 and 2007, repurchase agreements totaled $7,558,492 and
$7,067,421, respectively and had a weighted average rate of 0.25% and 3.38%,
respectively. At December 31, 2008 and 2007, repurchase agreements were
collateralized by U.S. government agency obligations with a principal balance of
$10,000,000. 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, 2008 and 2007, the
Company had approximately $125.1 million and $146.0 million, respectively, of
additional credit available with the FHLB.
  F-33
  10.
INCOME TAXES
 
 The
components of income tax expense for the years ended December 31, 2008, 2007 and
2006 are as follows:
 
 Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006CurrentFederal
                  
                  $
                  6,516,536
                  
                  
                  $
                  9,804,043
                  
                  
                  $
                  9,378,947State
                  
                  
                  1,280,846
                  
                  
                  
                  1,474,554
                  
                  
                  
                  1,894,6047,797,382
                  
                  
                  
                  11,278,597
                  
                  
                  
                  11,273,551DeferredFederal
                  
                  
                  (709,851
                  )
                  
                  
                  (361,087
                  )
                  
                  
                  (165,994
                  )State
                  
                  
                  (152,891
                  )
                  
                  
                  (77,773
                  )
                  
                  
                  (35,753
                  )(862,742
                  )
                  
                  
                  (438,860
                  )
                  
                  
                  (201,747
                  )Total
                  
                  $
                  6,934,640
                  
                  
                  $
                  10,839,737
                  
                  
                  $
                  11,071,804
 
 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, 2008, 2007 and 2006 are as follows:
 
 Years
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Expected
      income tax expense at 35%
                  
                  $
                  6,272,861
                  
                  
                  $
                  9,745,037
                  
                  
                  $
                  9,892,456State
      income taxes, net of federal income tax
                  
                  
                  733,171
                  
                  
                  
                  907,908
                  
                  
                  
                  1,208,253Other
      expenses and adjustments
                  
                  
                  (71,392
                  )
                  
                  
                  186,792
                  
                  
                  
                  (28,905
                  )Total
                  
                  $
                  6,934,640
                  
                  
                  $
                  10,839,737
                  
                  
                  $
                  11,071,804
 
 The
components of deferred income tax assets and liabilities are as
follows:
 
 Years
      Ended December 31,2008
                  
                  
                  2007Deferred
      income tax assetsDeferred
      directors' fees
                  
                  $
                  548,723
                  
                  
                  $
                  564,064Allowance
      for credit losses
                  
                  
                  4,624,544
                  
                  
                  
                  3,807,455Employee
      benefits
                  
                  
                  705,515
                  
                  
                  
                  725,388Loans
      mark-to-market
                  
                  
                  157,399
                  
                  
                  
                  166,214Other
                  
                  
                  265,822
                  
                  
                  
                  218,2006,302,003
                  
                  
                  
                  5,481,321Deferred
      income tax liabilitiesDepreciation
      and amortization
                  
                  
                  3,289,429
                  
                  
                  
                  3,152,318Carrying
      value – land
                  
                  
                  395,000
                  
                  
                  
                  395,000Mortgage
      servicing rights
                  
                  
                  397,261
                  
                  
                  
                  454,493Deferred
      loan origination fees and costs
                  
                  
                  845,136
                  
                  
                  
                  929,924FHLB
      stock
                  
                  
                  27,293
                  
                  
                  
                  65,346Unrealized
      gain on securities available for sale
                  
                  
                  770,079
                  
                  
                  
                  245,8175,724,198
                  
                  
                  
                  5,242,898Net
      deferred income tax asset
                  
                  $
                  577,805
                  
                  
                  $
                  238,423
 
 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%.
  F-34
  11.
REGULATORY CAPITAL REQUIREMENTS (Continued)
 
 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, 2008, 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, 2008, 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, 2008 and
2007 are presented in the table below (dollars in thousands):
 
 Minimum
      to be WellCapitalized
      underMinimum
      for Capital
                          
                          
                          Prompt
      CorrectiveActual
                          
                          
                          Adequacy Purposes
                          
                          
                          Action ProvisionsAmount
                          
                          
                          Ratio
                          
                          
                          Amount
                          
                          
                          Ratio
                          
                          
                          Amount
                          
                          
                          RatioDecember
      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
                          %December
      31, 2007:Total
      Capital (to Risk Weighted Assets)
                          
                          $
                          89,880
                          
                          
                          
                          12.2
                          %
                          
                          $
                          59,142
                          
                          
                          
                          8.0
                          %
                          
                          $
                          73,927
                          
                          
                          
                          10.0
                          %Tier
      1 Capital (to Risk Weighted Assets)
                          
                          
                          80,631
                          
                          
                          
                          10.9
                          %
                          
                          
                          29,571
                          
                          
                          
                          4.0
                          %
                          
                          
                          44,356
                          
                          
                          
                          6.0
                          %Tier
      1 Capital (to Average Assets)
                          
                          
                          80,631
                          
                          
                          
                          8.9
                          %
                          
                          
                          36,163
                          
                          
                          
                          4.0
                          %
                          
                          
                          45,204
                          
                          
                          
                          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,
2008, 2007 and 2006. Options to purchase 172,295, 255,919 and 538,374 shares of
common stock were outstanding at December 31, 2008, 2007, and 2006,
respectively.
 
 Years Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Net
      income (numerator)
                  
                  $
                  10,987,820
                  
                  
                  $
                  17,003,227
                  
                  
                  $
                  17,192,356Weighted
      average shares outstanding for basic EPS (denominator)
                  
                  
                  9,761,944
                  
                  
                  
                  9,914,929
                  
                  
                  
                  9,714,565Dilutive
      effect of stock options
                  
                  
                  19,817
                  
                  
                  
                  112,799
                  
                  
                  
                  288,304Adjusted
      shares for diluted EPS
                  
                  
                  9,781,761
                  
                  
                  
                  10,027,728
                  
                  
                  
                  10,002,869
 
 For the
years ended December 31, 2008 and 2007, there were 132,012 and 30,500 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 2008
and 2007.
  F-35
  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 $255,509,602, $254,670,534 and $245,632,810 at
December 31, 2008, 2007, and 2006 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, 2008 and 2007, mortgage servicing rights reported in the
consolidated statements of financial condition, net of amortization, were
$1,005,725 and $1,150,616 respectively.
 
 During
the years ended December 31, 2008 and 2007 respectively, the Company recorded
additional servicing assets of $257,930 and $247,154 as a result of sales of
loans or mortgage-backed securities. Amortization of servicing assets during the
years ended December 31, 2008, 2007, and 2006 aggregated $402,820, $363,068, and
$344,023, respectively. The fair value of recognized servicing assets amounted
to approximately $2,823,000 and $2,785,000 as of December 31, 2008 and 2007,
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 statement of financial condition.
 
 The
Company's exposure to credit loss in the event of non-performance by the other
party to the financial instrument 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.
 
 A summary
of the contractual amounts of the Company's exposure to off-balance sheet risk
as of December 31, 2008 and 2007 are as follows:
 
 December 31,2008
                    
                    
                    2007Commitments
      to extend credit
                    
                    $
                    66,428,000
                    
                    
                    $
                    122,786,000Undrawn
      balances on lines of credit and undrawn balances on credit reserves
      (overdraft protection)
                    
                    
                    51,504,000
                    
                    
                    
                    53,565,000Standby
      letters of credit
                    
                    
                    2,384,000
                    
                    
                    
                    1,416,000Total
                    
                    $
                    120,316,000
                    
                    
                    $
                    177,767,000
 
 Included
in the commitments to originate loans as of December 31, 2008 and December 31,
2007, are fixed interest rate loan commitments of approximately $14.5 million
and $13.6 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.
 
 The
Company's lending is concentrated primarily in Beaufort, Craven, Cumberland,
Currituck, Dare, Edgecombe, Lenoir, Durham, Nash, Pasquotank, Pitt, Robeson,
Wake, and surrounding counties in 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.
  F-36
 
 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, 2008, 2007 and 2006 are as
follows:
 
 Years Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006CONDENSED
      BALANCE SHEETSCash
                  
                  $
                  2,003,541
                  
                  
                  $
                  1,961,421
                  
                  
                  $
                  1,673,729Investment
      in wholly-owned subsidiary
                  
                  
                  86,637,727
                  
                  
                  
                  85,509,789
                  
                  
                  
                  81,093,299Other
      assets
                  
                  
                  11,437,376
                  
                  
                  
                  10,737,756
                  
                  
                  
                  8,003,533Total
      assets
                  
                  $
                  100,078,644
                  
                  
                  $
                  98,208,966
                  
                  
                  $
                  90,770,561Junior
      subordinated debentures
                  
                  $
                  10,310,000
                  
                  
                  $
                  10,310,000
                  
                  
                  $
                  10,310,000Other
      liabilities
                  
                  
                  1,947,619
                  
                  
                  
                  1,863,644
                  
                  
                  
                  1,663,983Stockholders'
      equity
                  
                  
                  87,821,025
                  
                  
                  
                  86,035,322
                  
                  
                  
                  78,796,578Total
      liabilities and stockholders' equity
                  
                  $
                  100,078,644
                  
                  
                  $
                  98,208,966
                  
                  
                  $
                  90,770,561CONDENSED
      STATEMENTS OF INCOMEInterest
      on junior subordinated debentures
                  
                  $
                  657,576
                  
                  
                  $
                  839,110
                  
                  
                  $
                  815,331Equity
      in earnings of subsidiary
                  
                  
                  11,481,054
                  
                  
                  
                  17,660,805
                  
                  
                  
                  17,846,544Miscellaneous
      income
                  
                  
                  164,342
                  
                  
                  
                  181,532
                  
                  
                  
                  161,143Net
      income
                  
                  $
                  10,987,820
                  
                  
                  $
                  17,003,227
                  
                  
                  $
                  17,192,356CONDENSED
      STATEMENTS OF CASH FLOWSOperating
      activities:Net
      income
                  
                  $
                  10,987,820
                  
                  
                  $
                  17,003,227
                  
                  
                  $
                  17,192,356Adjustments
      to reconcile net income to net cash provided by operating
      activities:Amortization
      of intangibles
                  
                  
                  18,767
                  
                  
                  
                  24,996
                  
                  
                  
                  24,996Equity
      in undistributed earnings of subsidiary
                  
                  
                  (11,481,054
                  )
                  
                  
                  (17,660,805
                  )
                  
                  
                  (17,846,544
                  )Other
      operating activities
                  
                  
                  (718,390
                  )
                  
                  
                  (2,674,648
                  )
                  
                  
                  (8,146,306
                  )Net
      cash used in operating activities
                  
                  
                  (1,192,857
                  )
                  
                  
                  (3,307,230
                  )
                  
                  
                  (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
                  
                  
                  11,156,103
                  
                  
                  
                  14,200,140
                  
                  
                  
                  15,115,171Net
      cash provided by investing activities
                  
                  
                  11,156,103
                  
                  
                  
                  14,200,140
                  
                  
                  
                  15,115,171Financing
      activities:Proceeds
      from exercise of stock options
                  
                  
                  640,063
                  
                  
                  
                  3,459,780
                  
                  
                  
                  1,093,576Purchase
      of treasury shares
                  
                  
                  (2,845,412
                  )
                  
                  
                  (6,722,276
                  )
                  
                  
                  (867,905
                  )Cash
      paid for dividends and fractional shares
                  
                  
                  (7,715,777
                  )
                  
                  
                  (7,342,722
                  )
                  
                  
                  (6,199,361
                  )Net
      cash used in financing activities
                  
                  
                  (9,921,126
                  )
                  
                  
                  (10,605,218
                  )
                  
                  
                  (5,973,690
                  )Net
      increase in cash
                  
                  
                  42,120
                  
                  
                  
                  287,692
                  
                  
                  
                  365,983Cash
      at beginning of year
                  
                  
                  1,961,421
                  
                  
                  
                  1,673,729
                  
                  
                  
                  1,307,746Cash
      at end of year
                  
                  $
                  2,003,541
                  
                  
                  $
                  1,961,421
                  
                  
                  $
                  1,673,729
  F-37
  16.
QUARTERLY FINANCIAL DATA (UNAUDITED)
 
 Summarized
unaudited quarterly financial data for the years ended December 31, 2008 and
2007 is as follows (dollars in thousands):
 
 Fourth
                    
                    
                    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
                    
                    
                    $
                    .40Fourth
                    
                    
                    Third
                    
                    
                    Second
                    
                    
                    First2007:Interest
      income
                    
                    $
                    17,591
                    
                    
                    $
                    17,639
                    
                    
                    $
                    17,525
                    
                    
                    $
                    17,322Interest
      expense
                    
                    
                    7,309
                    
                    
                    
                    7,295
                    
                    
                    
                    7,286
                    
                    
                    
                    7,220Provision
      for credit losses
                    
                    
                    150
                    
                    
                    
                    100
                    
                    
                    
                    100
                    
                    
                    
                    -Noninterest
      income
                    
                    
                    2,726
                    
                    
                    
                    2,544
                    
                    
                    
                    2,382
                    
                    
                    
                    2,484Noninterest
      expense
                    
                    
                    6,084
                    
                    
                    
                    5,816
                    
                    
                    
                    5,489
                    
                    
                    
                    5,521Income
      tax expense
                    
                    
                    2,638
                    
                    
                    
                    2,714
                    
                    
                    
                    2,721
                    
                    
                    
                    2,767Net
      income
                    
                    $
                    4,136
                    
                    
                    $
                    4,258
                    
                    
                    $
                    4,311
                    
                    
                    $
                    4,298Net
      income per common shareBasic
                    
                    $
                    .42
                    
                    
                    $
                    .43
                    
                    
                    $
                    .43
                    
                    
                    $
                    .43Diluted
                    
                    $
                    .42
                    
                    
                    $
                    .42
                    
                    
                    $
                    .43
                    
                    
                    $
                    .43
 
 17.
FAIR VALUES OF FINANCIAL INSTRUMENTS
 
 Statement
of Financial Accounting Standards No. 107, "Disclosures about Fair Value of
Financial Instruments" ("SFAS No. 107"), requires the disclosure of estimated
fair values for financial instruments. Quoted market prices, if available, are
utilized as an estimate of the fair value of financial instruments. Because no
quoted market prices exist for a significant part of the Company's financial
instruments, the fair value of such instruments has been derived based on
management's assumptions with respect to future economic conditions, the amount
and timing of future cash flows and estimated discount rates 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, 2008 and 2007 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:
  F-38
 
 17.
FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
 
 December 31, 2008
                  
                  
                  December 31, 2007Estimated
                  
                  
                  Carrying
                  
                  
                  Estimated
                  
                  
                  Carryingfair value
                  
                  
                  amount
                  
                  
                  fair value
                  
                  
                  amount1 -
      4 family mortgages
                  
                  $
                  47,316,937
                  
                  
                  $
                  46,128,989
                  
                  
                  $
                  50,990,827
                  
                  
                  $
                  50,460,903Consumer
                  
                  
                  102,289,498
                  
                  
                  
                  101,303,120
                  
                  
                  
                  99,659,781
                  
                  
                  
                  100,387,148Non-residential
                  
                  
                  597,299,188
                  
                  
                  
                  597,299,188
                  
                  
                  
                  614,234,854
                  
                  
                  
                  614,234,854Total
                  
                  $
                  746,905,623
                  
                  
                  $
                  744,731,297
                  
                  
                  $
                  764,885,462
                  
                  
                  $
                  765,082,905
 
 The fair
value of deposit liabilities with no stated maturities has been estimated to
equal the carrying amount (the amount payable on demand), totaling $249,921,423
and $261,145,369 at December 31, 2008 and 2007, 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, 2008 and 2007 are as follows:
 
 2008
                  
                  
                  2007Certificates
      of depositCarrying
      amount
                  
                  $
                  466,505,373
                  
                  
                  $
                  500,224,214Estimated
      fair value
                  
                  
                  473,896,700
                  
                  
                  
                  503,194,844Advances
      for Federal Home Loan Bank:Carrying
      amount
                  
                  $
                  45,000,000
                  
                  
                  $
                  35,000,000Estimated
      fair value
                  
                  
                  45,496,419
                  
                  
                  
                  35,000,000
 
 The
carrying amount of accrued interest receivable, FHLB stock, note 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 $120,316,000 and $177,767,000 at December 31,
2008 and 2007, respectively, which are primarily comprised of unfunded loan
commitments.
 
 18.
FAIR VALUE HIERACHY
 
 SFAS 157
established a fair value hierarchy to prioritize 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. SFAS 157 clarifies fair value in terms of the price
in an orderly transaction between market participants to sell an asset or
transfer a liability in the principal (or most advantageous) market for the
asset or liability at the measurement date (an exit price). In order to
determine the fair value or the exit price, entities must determine the unit of
account, highest and best use, principal market, and market
participants.  These determinations allow the reporting entity to
define the inputs for fair value and level of hierarchy.
 
 Outlined
below is the application of the fair value hierarchy established by SFAS 157 to
the Bank’s financial assets that are carried at 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.
  F-39
  18.
FAIR VALUE HIERACHY (Continued)
 
 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.
 
 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, 2008 were as
follows:
 
 Quoted
      Prices
                        in
      Active
                        Markets
      for
                        Identical
                        Assets
                      
                      
                      Significant
                        Other
                        Observable
                        Inputs
                      
                      
                      Significant
                        Unobservable
                        InputsDescription
                      
                      12/31/08
                      
                      
                      (Level
      1)
                      
                      
                      (Level
      2)
                      
                      
                      (Level
      3)Available
      for sale securities:Investment
                      
                      $
                      36,563,646
                      
                      
                      $
                      -
                      
                      
                      $
                      36,563,646
                      
                      
                      $
                      -Mortgage-backed
                      
                      
                      31,995,157
                      
                      
                      
                      -
                      
                      
                      
                      31,995,157
                      
                      
                      
                      -Other
      real estate owned
                      
                      
                      7,710,560
                      
                      
                      
                      -
                      
                      
                      
                      7,710,560
                      
                      
                      
                      -Total
                      
                      $
                      76,269,363
                      
                      
                      $
                      -
                      
                      
                      $
                      76,269,363
                      
                      
                      $
                      -
  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.
 
 Other
real estate owned acquired through loan foreclosure is recorded at fair value
based on the appraised market value of the property based on sales of similar
assets. The fair value may be subsequently reduced if the estimated fair value
declines below the original appraised value. Fair value adjustments of $772,000
were made to other real estate owned during the year ended December 31,
2008.  No liabilities were measured at fair value on a recurring basis
during the year ended December 31, 2008.
 
 Net gain
(loss) on sale of other real estate owned realized and included in earnings for
years ending December 31, 2008 and 2007 were ($80,542) and $49,644,
respectively.
 
 19.
SUPPLEMENTAL CASH FLOW INFORMATION
 
 Supplemental
cash flow information for the years ended December 31, 2008, 2007 and 2006 is as
follows:
 
 Year ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Real
      estate acquired in settlement of loans
                  
                  $
                  10,882,390
                  
                  
                  $
                  1,594,724
                  
                  
                  $
                  1,051,764Exchange
      of loans for mortgage-backed securities
                  
                  
                  3,399,071
                  
                  
                  
                  6,873,490
                  
                  
                  
                  17,203,225Cash
      paid for interest
                  
                  
                  23,358,551
                  
                  
                  
                  29,053,118
                  
                  
                  
                  25,572,320Cash
      paid for income taxes
                  
                  
                  7,567,051
                  
                  
                  
                  8,705,060
                  
                  
                  
                  8,360,047Dividends
      declared, not paid
                  
                  
                  1,947,619
                  
                  
                  
                  1,863,644
                  
                  
                  
                  1,663,983
  F-40
  20.
              JUNIOR
      SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST AND
      CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES OF
      SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE
  COMPANY
 
 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 FIN 46R,
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.
 
 Consolidated
debt obligations as of December 31, 2008 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, 2007
                  
                  $
                  1,561,149New
      extensions of credit made during the year
                  
                  
                  484,500Repayments
      during the year
                  
                  
                  (646,867
                  )Extensions
      of credit at December 31, 2008
                  
                  $
                  1,398,782
  F-41
  BOARD
OF DIRECTORS
 
 Frederick
      N. Holscher
                Marshall
      T. Singleton
                Linley
      H. Gibbs, Jr.
                Frederick
      H. HowdyChairman
                Vice
      Chairman
                Retired
                PresidentPartner
                Co-Owner
                Washington,
      NC
                Drs.
      Freshwater & Howdy, P.A.Rodman,
      Holscher, Francisco,
                B.
      E. Singleton & Sons
                
                Washington,
      NC&
      Peck, P.A.
                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,
      NC
 
 EXECUTIVE
OFFICERS
 
 Thomas
      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
      Operations Officer
                Chief
      Financial Officer and
                Chief
      Credit OfficerSecretarySherry
      L. Correll
                Paul
      S. Jaber
                Mary
      R. Boyd
                Kristie
      W. HawkinsExecutive
      Vice President
                Executive
      Vice President
                Executive
      Vice President
                Treasurer
      andBank
      Operations
                Mortgage
      Operations
                Loan
      Servicing
                Controller
 
 AREA
AND SUBSIDIARY EXECUTIVES
 
 Timothy
      M. Brown
                Dennis
      A. Nichols
                Donald
      B. Strickland, Jr.
                Donnie
      L. G. BunnSenior
      Vice President
                Senior
      Vice President
                Senior
      Vice President
                PresidentArea
      Executive
                Area
      Executive
                Area
      Executive
                First
      South Leasing, LLC.Cape
      Fear Region
                Neuse/Pamlico
      Region
                Tar
      Region
                Greenville,
      NC
 
 CITY
EXECUTIVES
 
 Jerry
      G. Hannah
                Joseph
      M. Johnson
                Thomas
      S. Lewis
                Kenneth
      W. Marshall, Jr.Vice
      President
                Senior
      Vice President
                Vice
      President
                Vice
      PresidentCity
      Executive
                City
      Executive
                City
      Executive
                City
      ExecutiveKinston,
      NC
                Durham,
      NC
                Rocky
      Mount, NC
                Outer
      Banks, NCRhonda
      B. McLeod
                Robert
      C. Pfeiffer
                Renee
      P. Richardson
                William
      P. StoneAssistant
      Vice President
                Senior
      Vice President
                Vice
      President
                Vice
      PresidentCity
      Executive
                City
      Executive
                City
      Executive
                City
      ExecutiveHope
      Mills, NC
                Elizabeth
      City, NC
                Fayetteville,
      NC
                Lumberton,
      NCClyle
      F. Swanner, Jr.Vice
      PresidentCity
      ExecutiveWashington,
      NC
  F-42
  FIRST
SOUTH BANK OFFICE LOCATIONS
 
 Buxton
                    Hope
      Mills
                    Raleigh47560
      NC Highway 12
                    3103
      North Main Street
                    4800
      Six Forks Road, Suite 115Buxton,
      NC 27920
                    Hope
      Mills, NC 28348
                    Raleigh,
      NC 27609(252)
      995-3250
                    (910)
      423-0952
                    (919)
      783-5222Chocowinity
                    Kill
      Devil Hills2999
      Highway 17 South
                    1906
      South Croatan Highway
                    TarboroChocowinity,
      NC 27817
                    Kill
      Devil Hills, NC 27948
                    100
      East Hope Lodge Street(252)
      940-4970
                    (252)
      441-9935
                    Tarboro,
      NC 27886(252)
      823-0157Dunn
                    Kinston904-A
      West Broad Street
                    2430
      Herritage Street
                    WashingtonDunn,
      NC 28334
                    Kinston,
      NC 28503
                    1311
      Carolina Avenue(910)
      892-2861
                    (252)
      523-9449
                    Washington,
      NC 27889(252)
      946-4178Durham
                    Lumberton4215-01
      University Drive
                    600
      North Chestnut Street
                    300
      North Market StreetDurham,
      NC 27707
                    Lumberton,
      NC 28359
                    Washington,
      NC 27889(919)
      403-1000
                    (910)
      739-3274
                    (252)
      940-4945Elizabeth
      City
                    3000
      North Elm Street
                    1328
      John Small Avenue604
      East Ehringhaus Street
                    Lumberton,
      NC 28359
                    Washington,
      NC 27889Elizabeth
      City, NC 27906
                    (910)
      608-5031
                    (252)
      940-5000(252)
      335-0848New
      Bern
                    Operations
      Center andFayetteville
                    202
      Craven Street
                    Credit
      Administration241
      Green Street
                    New
      Bern, NC 28561
                    220
      Creekside DriveFayetteville,
      NC 28302
                    (252)
      636-2997
                    Washington,
      NC 27889(910)
      483-3681
                    
                    (252)
      946-41781725
      Glenburnie Road705
      Executive Place
                    New
      Bern, NC 28561
                    Loan
      Production OfficesFayetteville,
      NC 28305
                    (252)
      636-3569
                    3804
      Peachtree Avenue, Unit 200(910)
      484-2116
                    
                    Wilmington,
      NC 284032019
      South Glenburnie Road
                    (910)
      798-6102Grantsboro
                    New
      Bern, NC 2856111560
      NC Highway 55
                    (252)
      637-1110Suite
      11
                    
                    First
      South LeasingGrantsboro,
      NC 28529
                    Rocky
      Mount
                    1035
      Director Court, Unit C(252)
      745-5001
                    300
      Sunset Avenue
                    Greenville,
      NC 27858Rocky
      Mount, NC 27804
                    (252)
    355-4536Greenville
                    (252)
      972-9661301
      East Arlington BoulevardGreenville,
      NC 27835
                    2901
      Sunset Avenue(252)
      321-2600
                    Rocky
      Mount, NC 27804(252)
      451-1259907
      East Firetower RoadGreenville,
      NC 27835
                    1378
      Benvenue Road(252)
      355-4644
                    Rocky
      Mount, NC 27804(252)
      442-83751707
      SE Greenville BoulevardGreenville,
      NC 27858
                    3635
      North Halifax Road(252)752-2770
                    Rocky
      Mount, NC 27804(252)
      451-8700
 
 Member
FDIC
  F-43
 
 STOCKHOLDER
INFORMATION
 
 Corporate
Headquarters
 First
      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 816 registered stockholders of record as of
March 2, 2009.
 
 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, 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
                    
                    
                    
                    .20March
      31, 2007
                    
                    $
                    32.06
                    
                    
                    $
                    25.35
                    
                    
                    $
                    .19June
      30, 2007
                    
                    
                    31.25
                    
                    
                    
                    26.50
                    
                    
                    
                    .19September
      30, 2007
                    
                    
                    29.85
                    
                    
                    
                    24.42
                    
                    
                    
                    .19December
      31, 2007
                    
                    
                    27.88
                    
                    
                    
                    22.01
                    
                    
                    
                    .19
 
 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 28, 2009 at 11:00 a.m. eastern standard 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
                  8305
      Falls of Neuse Road
                  509
      East Center StreetWashington,
      NC  27889
                  Raleigh,
      NC 27615
                  Lexington,
      NC 27292
  F-44
  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, 2003 through December 31, 2008 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, 2003 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.
  
  12/31/03
                  
                  
                  12/31/04
                  
                  
                  12/31/05
                  
                  
                  12/31/06
                  
                  
                  12/31/07
                  
                  
                  12/31/08First
      South Bancorp Inc.
                  
                  $
                  100.00
                  
                  
                  $
                  107.37
                  
                  
                  $
                  151.79
                  
                  
                  $
                  210.25
                  
                  
                  $
                  150.01
                  
                  
                  $
                  88.74NASDAQ
                  
                  $
                  100.00
                  
                  
                  $
                  110.08
                  
                  
                  $
                  112.88
                  
                  
                  $
                  126.51
                  
                  
                  $
                  138.13
                  
                  
                  $
                  80.47NASDAQ
      Bank
                  
                  $
                  100.00
                  
                  
                  $
                  111.11
                  
                  
                  $
                  108.64
                  
                  
                  $
                  123.74
                  
                  
                  $
                  97.71
                  
                  
                  $
                  74.73
 
  F-45
 
 First
South Bancorp
 
 1311
Carolina Avenue
 P.O. Box
2047
 Washington,
North Carolina 27889
 (252)
946-4178 • Fax (252) 946-3873
 www.firstsouthnc.com