**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**FORM
      10-K**


**x**
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


For
      the
      fiscal year ended December 31, 2007


OR


o
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE****ACT
                OF 1934**


For
      the
      transition period from _________ to _________





Commission
      File No. **0-22219**





**FIRST
      SOUTH BANCORP, INC.**


(Exact
      name of registrant as specified in its charter)





**Virginia**
            
            **56-1999749**(State or other jurisdiction of
            
            (I.R.S. Employerincorporation or organization)
            
            Identification No.)**1311 Carolina Avenue, Washington, North Carolina**
            
            **27889-2047**(Address of principal executive offices)
            
            (Zip Code)





Registrant’s
      telephone number, including area code: **(252)
      946-4178**





Securities
      registered pursuant to Section 12(b) of the Act:





**Common Stock (par value $0.01 per share)**
            
            **NASDAQ Global Select Market**(Title of Class)
            
            (Name of exchange onwhich registered)





Securities
      registered pursuant to Section 12(g) of the Act: **None**





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes o No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or 15(d) of the Act. Yes o No x





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or such shorter period that the registrant was required
      to
      file such reports), and (2) has been subject to such filing requirements for
      the
      past 90 days. Yes x No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. x





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company.
      See
      the definitions of “large accelerated filer,” “accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act (Check one):





Large
                accelerated filer o
            Accelerated
                filerxNon-accelerated
                filer o (Do not check if
                a smaller reporting company)
            Smaller
                reporting company o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes o No x





The
      aggregate market value of common stock held by nonaffiliates of the registrant
      at June 30, 2007, was approximately $220.7 million based on the closing sale
      price of the registrant’s Common Stock as listed on the Nasdaq Global Select
      Market as of the last business day of the registrant’s most recently completed
      second fiscal quarter. For purposes of this calculation, it is assumed that
      directors, executive officers and beneficial owners of more than 5% of the
      registrant’s outstanding voting stock are affiliates.





Number
      of
      shares of Common Stock outstanding as of March 7, 2008: 9,775,492.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





The
      following lists the documents incorporated by reference and the Part of the
      Form
      10K into which the document is incorporated:





1.
            Portions
              of the Annual Report to Stockholders for the fiscal year ended December
              31, 2007. (Part II) 2.
            Portions
                of Proxy Statement for the 2008 Annual Meeting of Stockholders. (Part
                II
                and Part III)







**PART
      I**





**Item
      1.**  **Business**





**Forward-Looking
      Statements**





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. This Annual Report on Form 10-K, contains forward looking
      statements that involve risk and uncertainty. In order to comply with the terms
      of the safe harbor, the Company notes that a variety of risks and uncertainties
      could cause its actual results and experience to differ materially from the
      anticipated results or other expectations expressed in the Company's forward
      looking statements. There are risks and uncertainties that may affect the
      operations, performance, development, growth projections and results of the
      Company's business. They include, but are not limited to, economic growth,
      interest rate movements, timely development of technology enhancements for
      products, services and operating systems, the impact of competitive products,
      services and pricing, customer requirements, regulatory changes and similar
      matters. Readers of this report are cautioned not to place undue reliance on
      forward looking statements that are subject to influence by these risk factors
      and unanticipated events. Accordingly, actual results may differ materially
      from
      management's expectations.





**General**





*First
      South Bancorp, Inc.* First
      South Bancorp, Inc. (the “Company”) is a Virginia corporation that serves as the
      holding company for First South Bank, a North Carolina chartered commercial
      bank
      (the “Bank”). The Company’s principal business is overseeing the business of the
      Bank and operating through the Bank a commercial banking business. The Bank
      has
      one significant operating segment, the providing of general commercial banking
      services to its markets located in the state of North Carolina. The Company’s
      common stock is traded on the Nasdaq Global under the symbol
“FSBK”.





*First
      South Bank.* The
      Bank
      is a North Carolina chartered commercial bank headquartered in Washington,
      North
      Carolina and serves Eastern North Carolina. The Bank received federal insurance
      of its deposits in 1959.





The
      Bank’s principal business consists of attracting deposits from the general
      public and investing these funds in commercial real estate loans, commercial
      business loans, consumer loans and loans secured by first mortgages on
      owner-occupied, single-family residences in the Bank’s market area.





The
      Bank
      derives its income principally from interest earned on loans and investments
      and, to a lesser extent, loan servicing and other fees and gains on the sale
      of
      loans and investments. The Bank’s principal expenses are interest expense on
      deposits and borrowings and noninterest expense such as compensation and
      employee benefits, office occupancy expenses and other miscellaneous expenses.
      Funds for these activities are provided principally by deposits, repayments
      of
      outstanding loans and investments and operating revenues.





**Market
      Area**





The
      Company makes loans and obtains deposits throughout central, eastern,
      northeastern and southeastern North Carolina, where the Bank’s offices are
      located. As of December 31, 2007, management estimates that more than 95% of
      deposits and 90% of loans came from its primary market area.





The
      economy of the Company’s primary market area is diversified, with employment
      distributed among manufacturing, agriculture and non-manufacturing activities.
      There are a significant number of major employers in the Company’s primary
      market area. The unemployment rate in the Company’s market area is equivalent to
      the national average and the unemployment rate for the State of North Carolina.





**Critical
      Accounting Policies**





The
      Company has identified the policies below as critical to its business operations
      and the understanding of its results of operations. The impact and any
      associated risks related to these policies on the Company’s business operations
      is discussed throughout Management’s Discussion and Analysis of Financial
      Condition and Results of Operations where such policies affect reported and
      expected financial results.


1





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





*Loans
      Impairment, Allowance for Loan and Lease Losses and Unfunded Loan Commitments.* A
      loan or
      lease 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
      or
      lease 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 or lease is impaired. The internal
      asset classification procedures include a thorough review of significant loans,
      leases and lending relationships and include the accumulation of related data.
      This data includes loan and lease payment status, borrowers’ financial data and
      borrowers’ operating factors such as cash flows, operating income or loss,
      etc.





The
      allowance for loan and lease losses and unfunded loan commitments are increased
      by charges to income and decreased by charge-offs (net of recoveries).
      Management’s periodic evaluation of the adequacy of the allowance for loan and
      lease losses and unfunded loan commitments is based on the Bank’s past loan and
      lease loss experience, known and inherent risks in the loan and lease portfolio
      and in unfunded loan commitments, 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 for loan and lease losses and unfunded loan
      commitments 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 in the future
      that regulators or risks in its loan and lease portfolio and in unfunded loan
      commitments will not require adjustments to the allowance for loan and lease
      losses and unfunded loan commitments.





*Income
      Taxes.* **** Deferred
      tax asset and liability balances are determined by application to temporary
      differences of the tax rate expected to be in effect when taxes will become
      payable or receivable. Temporary differences are differences between the tax
      basis of assets and liabilities and their reported amounts in the financial
      statements that will result in taxable or deductible amounts in future years.
      The effect on deferred taxes of a change in tax rates is recognized in income
      in
      the period that includes the enactment date.





*Off-Balance
      Sheet 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 balance sheet.





The
      Company’s exposure to credit loss in the event of nonperformance 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.





**Lending
      Activities**





*General.* The
      Company’s gross loan portfolio, including real estate construction loans in
      process, totaled $833.2 million at December 31, 2007, representing 91.6% of
      total assets at that date. It is the Company’s policy to concentrate its lending
      within its market area. The Company originates a significant amount of
      commercial real estate loans. At December 31, 2007, commercial real estate
      and
      construction loans amounted to $610.7 million, or 73.3% of the Company’s gross
      loan portfolio. The Company has no direct sub-prime or Alt-A loan exposure
      in
      its loan portfolio. In recent years, the Company has sought to increase
      originations of commercial business loans and consumer loans. At December 31,
      2007, commercial business loans totaled $49.0 million, or 5.9% of the Company’s
      gross loan portfolio, and consumer loans totaled $104.4 million, or 12.5% of
      the
      Company’s gross loan portfolio. To a lesser extent, the Company also originates
      multi-family residential real estate loans. At December 31, 2007, $41.2 million,
      or 4.9% of the Company’s gross loan portfolio, consisted of single-family,
      residential mortgage loans. The Company’s residential mortgage construction
      loans totaled $12.5 million, or 1.5% of the Company’s gross loan portfolio, at
      December 31, 2007.


2


*Loan
      Portfolio Composition.* The
      following table sets forth selected data relating to the composition of the
      Company’s loan portfolio by type of loan at the
      dates
      indicated. At December 31, 2007, the Company had no concentrations of loans
      exceeding 10% of gross loans other than as disclosed below.


At December 31,2007
              
              2006
              
              2005
              
              2004
              
              2003Amount
              
              %
              
              Amount
              
              %
              
              Amount
              
              %
              
              Amount
              
              %
              
              Amount
              
              %(Dollars in thousands)Residential
                mortgage loans:Single-family
                  residential
              
              $
              41,223
              
              
              4.9
              %
              $
              62,352
              
              
              7.5
              %
              $
              49,363
              
              
              6.2
              %
              $
              53,149
              
              
              7.6
              %
              $
              64,549
              
              
              10.8
              %Multi-family
                  residential
              
              
              2,255
              
              
              0.3
              
              
              2,897
              
              
              0.4
              
              
              2,885
              
              
              0.4
              
              
              2,956
              
              
              0.4
              
              
              3,650
              
              
              0.6Construction
              
              
              12,508
              
              
              1.5
              
              
              13,211
              
              
              1.6
              
              
              25,304
              
              
              3.1
              
              
              22,687
              
              
              3.3
              
              
              9,921
              
              
              1.7Total
                  residential mortgage
                  loans
              
              
              55,986
              
              
              6.7
              
              
              78,460
              
              
              9.5
              
              
              77,552
              
              
              9.7
              
              
              78,792
              
              
              11.3
              
              
              78,120
              
              
              13.1Commercial
                loans and leases:Commercial
                  real estate
              
              
              436,135
              
              
              52.3
              
              
              391,315
              
              
              47.3
              
              
              377,407
              
              
              47.2
              
              
              317,013
              
              
              45.4
              
              
              223,166
              
              
              37.3Commercial
                  construction
              
              
              174,576
              
              
              21.0
              
              
              194,863
              
              
              23.6
              
              
              193,062
              
              
              24.2
              
              
              153,796
              
              
              22.0
              
              
              149,264
              
              
              25.0Commercial
                  business
              
              
              48,986
              
              
              5.9
              
              
              42,645
              
              
              5.2
              
              
              38,457
              
              
              4.8
              
              
              38,891
              
              
              5.6
              
              
              47,646
              
              
              7.9Lease
                  receivables
              
              
              13,101
              
              
              1.6
              
              
              12,640
              
              
              1.5
              
              
              11,981
              
              
              1.5
              
              
              11,622
              
              
              1.6
              
              
              10,422
              
              
              1.7Total
                  commercial loans and
                  leases
              
              
              672,798
              
              
              80.8
              
              
              641,463
              
              
              77.6
              
              
              620,907
              
              
              77.7
              
              
              521,322
              
              
              74.6
              
              
              430,498
              
              
              71.9Consumer
                loans:Automobile
              
              
              3,518
              
              
              0.4
              
              
              3,748
              
              
              0.5
              
              
              4,851
              
              
              0.6
              
              
              3,890
              
              
              0.5
              
              
              4,045
              
              
              0.7Savings
                  account
                  loans
              
              
              1,793
              
              
              0.2
              
              
              2,639
              
              
              0.3
              
              
              1,826
              
              
              0.2
              
              
              1,394
              
              
              0.2
              
              
              1,829
              
              
              0.3Home
                  equity loans
              
              
              43,558
              
              
              5.2
              
              
              42,153
              
              
              5.1
              
              
              42,084
              
              
              5.3
              
              
              42,330
              
              
              6.1
              
              
              38,533
              
              
              6.5Other
              
              
              55,544
              
              
              6.7
              
              
              57,945
              
              
              7.0
              
              
              51,783
              
              
              6.5
              
              
              50,827
              
              
              7.3
              
              
              45,072
              
              
              7.5Total
                  consumer
                  loans
              
              
              104,413
              
              
              12.5
              
              
              106,485
              
              
              12.9
              
              
              100,544
              
              
              12.6
              
              
              98,441
              
              
              14.1
              
              
              89,479
              
              
              15.0Total
              
              
              833,197
              
              
              100.0
              %
              
              826,408
              
              
              100.0
              %
              
              799,003
              
              
              100.0
              %
              
              698,555
              
              
              100.0
              %
              
              598,097
              
              
              100.0
              %Less:Construction
                  loans in process
              
              
              57,242
              
              
              
              
              
              54,390
              
              
              
              
              
              80,528
              
              
              
              
              
              57,194
              
              
              
              
              
              36,280Deferred
                  fees and
                  discounts
              
              
              1,386
              
              
              
              
              
              1,423
              
              
              
              
              
              1,433
              
              
              
              
              
              1,202
              
              
              
              
              
              983Allowance
                  for loan and lease
                  losses
              
              
              9,486
              
              
              
              
              
              9,158
              
              
              
              
              
              8,113
              
              
              
              
              
              8,343
              
              
              
              
              
              7,634Total
              
              $
              765,083
              
              
              
              
              $
              761,437
              
              
              
              
              $
              708,929
              
              
              
              
              $
              631,816
              
              
              
              
              $
              553,200


3


*Unfunded
      Commitments Composition.* The
      following table sets forth selected data relating to the composition of the
      Company’s unfunded commitments by type of loan at the date
      indicated.


At December 31,2007
                  
                  2006Amount
                  
                  %
                  
                  Amount
                  
                  %(Dollars in thousands)Residential
                    mortgage loans:Construction
                  
                  $
                  4,796
                  
                  
                  3.2
                  %
                  $
                  3,770
                  
                  
                  2.6
                  %Total
                      residential mortgage loans
                  
                  
                  4,796
                  
                  
                  3.2
                  
                  
                  3,770
                  
                  
                  2.6Commercial
                    loans and leases:Real
                      estate secured
                  
                  
                  16,815
                  
                  
                  11.1
                  
                  
                  12,244
                  
                  
                  8.3Non-Real
                      Estate
                  
                  
                  19,610
                  
                  
                  13.0
                  
                  
                  20,060
                  
                  
                  13.6Standby
                      Letters of Credit
                  
                  
                  1,416
                  
                  
                  0.9
                  
                  
                  2,720
                  
                  
                  1.9Construction
                  
                  
                  49,727
                  
                  
                  33.0
                  
                  
                  47,920
                  
                  
                  32.6Total
                      commercial loans and leases
                  
                  
                  87,568
                  
                  
                  58.0
                  
                  
                  82,944
                  
                  
                  56.4Consumer
                    loans:Home
                      equity loans
                  
                  
                  47,911
                  
                  
                  31.7
                  
                  
                  48,590
                  
                  
                  33.0Real
                      Estate Secured
                  
                  
                  42
                  
                  
                  0.1
                  
                  
                  166
                  
                  
                  0.1Non-Real
                      Estate
                  
                  
                  7,845
                  
                  
                  5.2
                  
                  
                  8,935
                  
                  
                  6.1Construction
                  
                  
                  2,720
                  
                  
                  1.8
                  
                  
                  2,699
                  
                  
                  1.8Total
                      consumer loans
                  
                  
                  58,518
                  
                  
                  38.8
                  
                  
                  60,390
                  
                  
                  41.0Total
                      Unfunded Commitments
                  
                  $
                  150,882
                  
                  
                  100.0
                  %
                  $
                  147,104
                  
                  
                  100.0
                  %


*Loan
      Maturities.* The
      following table sets forth certain information at December 31, 2007 regarding
      the dollar amount of loans maturing in the Company’s portfolio based on their
      maturity and repricing terms, including scheduled repayments of principal.
      Demand loans, loans having no stated schedule of repayments and no stated
      maturity, and overdrafts are reported as due in one year or less. The table
      does
      not include any estimate of prepayments which significantly shorten the average
      life of mortgage loans and may cause the Company’s repayment experience to
      differ from that shown below. Loan balances are net of construction loans in
      process. Lease balances are included in other loans.





Due One
              Year or
              Less
            
            Due After 1
              Through 5 Years
              After December
              31, 2007
            
            Due After 5 or
              More Years After
              December 31,
              2007
            
            Total(In
                thousands)Residential
                real estate loans
            
            $
            44,628
            
            $
            73,269
            
            $
            47,453
            
            $
            165,350Commercial
                real estate, business and other loans
            
            
            267,233
            
            
            262,294
            
            
            81,078
            
            
            610,605Total
            
            $
            311,861
            
            $
            335,563
            
            $
            128,531
            
            $
            755,955





The
      following table sets forth at December 31, 2007 the dollar amount of all loans
      due one year or more after December 31, 2007 which have predetermined interest
      rates and have floating or adjustable interest rates.


Predetermined
                Rates
              
              Floating or
                AdjustableRates(In
                  thousands)Residential
                  real estate loans
              
              $
              86,376
              
              $
              34,346Commercial
                  real estate, business andother
                  loans
              
              
              230,820
              
              
              112,552Total
              
              $
              317,196
              
              $
              146,898
  4





Scheduled
      contractual principal repayments of loans do not reflect the actual life of
      such
      assets. The average life of loans can be substantially less than their
      contractual terms because of prepayments. In addition, due-on-sale clauses
      on
      loans generally give the Bank the right to declare a loan immediately due and
      payable in the event, among other things, that the borrower sells the real
      property subject to the mortgage and the loan is not repaid. The average life
      of
      mortgage loans tends to increase when current mortgage loan market rates are
      substantially higher than rates on existing mortgage loans and, conversely,
      decrease when current mortgage loan market rates are substantially lower than
      rates on existing mortgage loans.





*Originations,
      Purchases and Sales of Loans* .
      The
      Bank generally has authority to originate and purchase loans secured by real
      estate located throughout the state of North Carolina and the United States.
      Consistent with its emphasis on being a community-oriented financial
      institution, the Bank concentrates its lending activities in its market
      area.





The
      Bank’s loan originations are derived from a number of sources, including
      referrals from depositors and borrowers, repeat customers, advertising, calling
      officers as well as walk-in customers. The Bank’s solicitation programs consist
      of advertisements in local media, in addition to participation in various
      community organizations and events. Real estate loans are originated by the
      Bank’s loan personnel. The Bank’s loan personnel consists of both salaried with
      an annual incentive and commission paid mortgage loan officers. Loan
      applications are accepted at the Bank’s offices. Historically, the Bank
      generally has not purchased loans. However, the Bank may in the future consider
      making limited loan purchases, including purchases of commercial
      loans.





In
      recent
      years, the Bank has sold or exchanged for mortgage-backed securities a
      significant amount of fixed-rate, single-family mortgage loans that it
      originated. During the years ended December 31, 2007, 2006 and 2005, these
      transactions totaled $42.2 million, $18.4 million and $29.2 million,
      respectively. Such loans are sold to or exchanged with the Federal Home Loan
      Mortgage Corporation (“FHLMC”). The Bank generally retains servicing on loans
      sold or exchanged to FHLMC.





*Loan
      Underwriting Policies* .
      The
      Bank’s lending activities are subject to the Bank’s written, non-discriminatory
      underwriting standards, its outside investors and to loan origination procedures
      prescribed by the Bank’s Board of Directors and its management. Detailed loan
      applications are obtained to determine the borrower’s ability to repay, and the
      more significant items on these applications are verified through the use of
      credit reports, financial information and confirmations. The Bank uses an
      automated underwriting software program owned by FHLMC named Loan Prospector
      on
      the majority of loans underwritten for sale to FHLMC. In addition, loans sold
      to
      other investors may be manually underwritten by the Bank or the respective
      investor, or the respective investor’s representatives, or through an investor’s
      automated underwriting system, if applicable. All large loans are presented
      weekly by the management loan committee to a loan committee of the Board of
      Directors of the Bank, made up of three outside directors who serve on a
      rotating basis. The President does not serve on the loan committee of the Board
      of Directors. Individual officers of the Bank have been granted authority by
      the
      Board of Directors to approve consumer and commercial loans up to varying
      specified dollar amounts, depending upon the type of loan and the lender’s level
      of expertise. In addition, committees of loan officers have loan authorities
      greater than individual authorities. These authorities are based on aggregate
      borrowings of an individual or entity. Any loans to a single borrower over
      $1,500,000 must be approved by the Loan Committee. On a monthly basis, the
      full
      Board of Directors reviews the actions taken by the loan committee.





Applications
      for single-family real estate loans are underwritten and closed in accordance
      with the standards of FHLMC or the investor’s guidelines. Generally, upon
      receipt of a loan application from a prospective borrower, a credit report
      and
      verifications are ordered, or obtained, to verify specific information relating
      to the loan applicant’s employment, income and credit standing. If a proposed
      loan is to be secured by a mortgage on real estate, an appraisal of the real
      estate is usually undertaken either by an appraiser approved by the Bank and
      licensed by the State of North Carolina or an evaluation by a qualified Bank
      personnel. In the case of single-family residential mortgage loans, except
      when
      the Bank becomes aware of a particular risk of environmental contamination,
      the
      Bank generally does not obtain a formal environmental report on the real estate
      at the time a loan is made. A formal environmental report may be required in
      connection with nonresidential real estate loans.





It
      is the
      Bank’s policy to record a lien on the real estate securing a loan and to obtain
      title insurance which insures that the property is free of prior encumbrances
      and other possible title defects. Borrowers must also obtain hazard insurance
      policies prior to closing and, when the property is in a flood plain as
      designated by the Federal Emergency Management Agency (FEMA), obtain flood
      insurance.


5





With
      respect to single-family residential mortgage loans, the Bank makes a loan
      commitment of between 15 and 90 days for each loan approved. If the borrower
      desires a longer commitment, the commitment may be extended for good cause
      and
      upon written approval. Fees of between $175 and $600 are charged in connection
      with the issuance of a commitment letter. The interest rate is guaranteed for
      the commitment period.





If
      the
      amount of a residential loan originated or refinanced exceeds 80% of the lesser
      of the appraised value or contract price, the Bank’s policy generally is to
      obtain private mortgage insurance at the borrower’s expense on that portion of
      the principal amount of the loan that exceeds 80%. The Bank will make a
      single-family residential mortgage loan with up to a 100% loan-to-value ratio
      if
      the required private mortgage insurance is obtained. The Bank generally limits
      the loan-to-value ratio on commercial real estate mortgage loans to 85%,
      although the loan-to-value ratio on commercial real estate loans in limited
      circumstances has been as high as 100%. The Bank limits the loan-to-value ratio
      on multi-family residential real estate loans to 85%.





The
      Bank
      is subject to regulations that limit the amount the Bank can lend to one
      borrower. See “— Depository Institution Regulation — Limits on Loans to One
      Borrower.” Under these limits, the Bank’s loans-to-one-borrower were limited to
      $14.3 million at December 31, 2007. At that date, the Bank had no lending
      relationships in excess of the loans-to-one-borrower limit.




Interest
      rates charged by the Bank on loans are affected principally by competitive
      factors, the demand for such loans and the supply of funds available for lending
      purposes. These factors are, in turn, affected by general economic conditions,
      monetary policies of the federal government, including the Federal Reserve
      Board, legislative tax policies and government budgetary matters.





*Single-Family
      Residential Real Estate Lending.* The Bank
      historically has been and continues to be an originator of single-family,
      residential real estate loans in its market area. At December 31, 2007,
      single-family, residential mortgage loans, excluding home improvement loans,
      totaled $41.2 million, or 4.9% of the Company’s gross loan
      portfolio.





The
      Bank
      originates fixed-rate mortgage loans at competitive interest rates. At December
      31, 2007, $25.6 million, or 45.8%, of the Company’s residential mortgage loan
      portfolio was comprised of fixed-rate residential mortgage loans. Generally,
      the
      Company retains fixed-rate mortgages with maturities of 15 years or less while
      fixed-rate loans with longer maturities may be retained in portfolio or sold
      in
      the secondary market. The Bank also offers conventional and government mortgage
      loans in its market area, which are underwritten, closed and sold to an outside
      investor.





The
      Bank
      also offers adjustable-rate residential mortgage loans. The adjustable-rate
      loans currently offered by the Bank have interest rates which adjust every
      one,
      three, five or seven years from the closing date of the loan or on an annual
      basis commencing after an initial fixed-rate period of one, three or five years
      in accordance with a designated index (the primary index utilized by the Bank
      is
      the weekly average yield on U.S. Treasury securities adjusted to a constant
      comparable maturity equal to the loan adjustment period, as made available
      by
      the Federal Reserve Board (the “Treasury Rate”)), plus a stipulated margin. The
      Bank offers adjustable-rate loans that meet FHLMC standards, as well as loans
      that do not meet such standards. The Bank’s adjustable-rate single-family
      residential real estate loans that do not meet FHLMC standards have a cap of
      generally 2% on any increase in the interest rate at any adjustment date, and
      include a cap on the maximum interest rate over the life of the loan, which
      cap
      generally is 3% to 5% above the initial rate. In return for providing a
      relatively low cap on interest rate increases over the life of the loan, the
      Bank’s adjustable-rate loans provide for a floor on the minimum interest rate
      over the life of the loan, which floor generally is the initial rate. Further,
      the Bank generally does not offer “teaser” rates, *i.e.* ,
      initial
      rates below the fully indexed rate, on such loans. The adjustable-rate mortgage
      loans offered by the Bank that do conform to FHLMC standards have a cap of
      6%
      above the initial rate over the life of a loan but do not include a floor,
      may
      be offered with a teaser rate and have a 25 basis point lower margin above
      the
      index on which the interest rate is based. All of the Bank’s adjustable-rate
      loans require that any payment adjustment resulting from a change in the
      interest rate of an adjustable-rate loan be sufficient to result in full
      amortization of the loan by the end of the loan term and, thus, do not permit
      any of the increased payment to be added to the principal amount of the loan,
      or
      so-called negative amortization. At December 31, 2007, $30.3 million, or 54.2%,
      of the Company’s residential mortgage loans were adjustable-rate
      loans.


6


The
      retention of adjustable-rate loans in the Company’s portfolio helps reduce the
      Company’s exposure to increases or decreases in prevailing market interest
      rates. However, there are unquantifiable credit risks resulting from potential
      increases in costs to borrowers in the event of upward repricing of
      adjustable-rate loans. It is possible that during periods of rising interest
      rates, the risk of default on adjustable-rate loans may increase due to
      increases in interest costs to borrowers. Further, although adjustable-rate
      loans allow the Company to increase the sensitivity of its interest-earning
      assets to changes in interest rates, the extent of this interest sensitivity
      is
      limited by the initial fixed-rate period before the first adjustment and the
      lifetime interest rate adjustment limitations. Accordingly, there can be no
      assurance that yields on the Company’s adjustable-rate loans will fully adjust
      to compensate for increases in the Company’s cost of funds.





*Construction
      Lending.* The Bank
      also offers residential and commercial construction loans, with a substantial
      portion of such loans originated to date being for the construction of
      owner-occupied, single-family dwellings in the Bank’s primary market area.
      Residential construction loans are offered primarily to individuals building
      their primary, investment or secondary residence, as well as to selected local
      developers to build single-family dwellings. Generally, loans to owner/occupants
      for the construction of owner-occupied, single-family residential properties
      are
      originated in connection with the permanent loan on the property and have a
      construction term of six to 18 months. Such loans are offered on a fixed-rate
      or
      adjustable-rate basis. Interest rates on residential construction loans made
      to
      the owner/occupant have interest rates during the construction period of 0.5%
      or
      more above the rate offered by the Bank on the permanent loan product selected
      by the borrower. Upon completion of construction, the permanent loan rate will
      be set at the rate then offered by the Bank on that permanent loan product,
      not
      to exceed the predetermined permanent rate cap. Interest rates on residential
      construction loans to builders are set at the prime rate plus a margin of
      between 0% and 1% and adjust either monthly or daily. Interest rates on
      commercial construction loans are generally based on the prime rate plus a
      negotiated margin of between 0% and 1% and adjust either monthly or daily,
      with
      construction terms generally not exceeding 18 months. Advances are made on
      a
      percentage of completed basis. At December 31, 2007, residential and commercial
      construction loans totaled $12.5 million and $174.6 million, respectively,
      which
      amounted to 1.5% and 21.0%, respectively, of the Company’s gross loan
      portfolio.





Prior
      to
      making a commitment to fund a loan, the Bank requires an appraisal of the
      property by appraisers approved by the Board of Directors for loans in excess
      of
      $250,000. For loans under $250,000, the Bank requires an evaluation of the
      property by qualified Bank personnel. The Bank also reviews and inspects each
      project at the commencement of construction and periodically during the term
      of
      the construction loan. The Bank generally charges a 0.50% to 1.25% construction
      loan fee for speculative builder loans. For construction loans to
      owner-occupants, the Bank generally charges a 0.5% to 1.0% construction loan
      fee. For residential construction loans, the Bank generally charges a commitment
      fee ranging from $275 to $500.





Construction
      financing generally is considered to involve a higher degree of risk of loss
      than long-term financing on improved, occupied real estate. Risk of loss on
      a
      construction loan is dependent largely upon the accuracy of the initial estimate
      of the property’s value at completion of construction or development and the
      estimated cost (including interest) of construction. During the construction
      phase, a number of factors could result in delays and cost overruns. If the
      estimate of construction costs proves to be inaccurate and the borrower is
      unable to meet the Bank’s requirements of putting up additional funds to cover
      extra costs or change orders, then the Bank will demand that the loan be paid
      off and, if necessary, institute foreclosure proceedings, or refinance the
      loan.
      If the estimate of value proves to be inaccurate, the Bank may be confronted,
      at
      or prior to the maturity of the loan, with collateral having a value which
      is
      insufficient to assure full repayment. The Bank has sought to minimize this
      risk
      by limiting construction lending to qualified borrowers ( *i.e.* ,
      borrowers who satisfy all credit requirements and whose loans satisfy all other
      underwriting standards which would apply to the Bank’s permanent mortgage loan
      financing for the subject property) in the Bank’s market area. On loans to
      builders, the Bank works only with selected builders with whom it has experience
      and carefully monitors the creditworthiness of the builders. Builder
      relationships are analyzed and underwritten annually by the Bank’s credit
      administration department.





*Multi-Family
      Residential and Commercial Real Estate Lending.* The Bank
      originates commercial real estate loans, as well as a limited amount of
      multi-family residential real estate loans, generally limiting such originations
      to loans secured by properties in its primary market area and to borrowers
      with
      whom it has other loan relationships. The Company’s multi-family residential
      loan portfolio consists primarily of loans secured by small apartment buildings,
      and the commercial real estate loan portfolio includes loans to finance the
      acquisition of small office buildings and commercial and industrial buildings
      with a preference to owner occupied. Such loans generally range in size from
      $100,000 to $2.0 million. At December 31, 2007, multi-family residential and
      commercial real estate loans totaled $2.3 million and $436.1 million,
      respectively, which amounted to 0.3% and 52.3%, respectively, of the Company’s
      gross loan portfolio. Multi-family and commercial real estate loans are
      originated either for three to seven year terms with interest rates that adjust
      based on either the prime rate as quoted in The
      Wall Street Journal ** plus
      a
      negotiated margin of between 0% and 1% for shorter term loans, or on a
      fixed-rate basis with interest calculated on a 15 to 25-year amortization
      schedule generally with a balloon payment due after three to seven
      years.


7





Multi-family
      residential and commercial real estate lending entails significant additional
      risks as compared with single-family residential property lending. Multi-family
      residential and commercial real estate loans typically involve larger loan
      balances to single borrowers or groups of related borrowers. The payment
      experience on such loans typically is dependent on the successful operation
      of
      the real estate project, retail establishment or business. These risks can
      be
      significantly affected by supply and demand conditions in the market for office,
      retail and residential space, and, as such, may be subject to a greater extent
      to adverse conditions in the economy generally. To minimize these risks, the
      Bank generally limits itself to its market area or to borrowers with which
      it
      has prior experience or who are otherwise known to the Bank. It has been the
      Bank’s policy to obtain annual financial statements of the business of the
      borrower or the project for which commercial or multi-family residential real
      estate loans are made for loans over $1,000,000. In addition, in the case of
      commercial mortgage loans made to a partnership or a corporation, the Bank
      obtains personal guarantees from an owner with 20% or more interest in the
      company and for loans over $1,000,000 annual financial statements of the
      principals of the partnership or corporation.





*Commercial
      Lending.* The
      Company’s commercial loans consist of loans secured by commercial real estate
      and commercial business loans, which are not secured by real estate. For a
      discussion of the Company’s commercial real estate lending see “— Multi-Family
      and Commercial Real Estate Lending.”





As
      a
      commercial bank, the Bank originates commercial business loans. The Bank
      originates commercial business loans to small and medium sized businesses in
      its
      market area. The Bank’s commercial borrowers are generally small businesses
      engaged in manufacturing, distribution or retailing, or service professionals
      in
      healthcare, accounting and law. Commercial business loans are generally made
      to
      finance the purchase of inventory, new or used equipment or commercial vehicles,
      to support trading assets and for short-term working capital. Such loans
      generally are secured by equipment and inventory, and, if possible,
      cross-collateralized by a real estate mortgage, although commercial business
      loans are sometimes granted on an unsecured basis. Such loans generally are
      made
      for terms of five years or less, depending on the purpose of the loan and the
      collateral, with loans to finance operating expenses made for one year or less,
      with interest rates that typically either adjust daily at a rate equal to the
      prime rate as stated in The
      Wall Street Journal plus a
      margin of between 0% and 2% or at a negotiated fixed rate. Generally, commercial
      loans are made in amounts ranging between $5,000 and $5,000,000. At December
      31,
      2007, commercial business loans totaled $49.0 million, or 5.9% of the Company’s
      gross loan portfolio.





The
      Bank
      underwrites its commercial business loans on the basis of the borrower’s cash
      flow and ability to service the debt from earnings rather than on the basis
      of
      underlying collateral value, and the Bank seeks to structure such loans to
      have
      more than one source of repayment. The borrower is required to provide the
      Bank
      with sufficient information to allow the Bank to make its lending determination.
      In most instances, this information consists of at least two years of financial
      statements, a statement of projected cash flows, current financial information
      on any guarantor and any additional information on the collateral. For most
      commercial loans over $50,000 with maturities exceeding one year, the Bank
      requires that borrowers and guarantors provide updated financial information
      at
      least annually throughout the term of the loan.





The
      Bank’s commercial business loans may be structured as short-term loans, term
      loans or as lines of credit. Short-term commercial business loans are for
      periods of 12 months or less and are generally self-liquidating from asset
      conversion cycles. Commercial business term loans are generally made to finance
      the purchase of assets and have maturities of five years or less. Commercial
      business lines of credit are typically made for the purpose of supporting
      trading assets and providing working capital. Such loans are usually approved
      with a term of 12 months and are reviewed annually. The Bank also offers secured
      standby letters of credit for its commercial borrowers. The terms of standby
      letters of credit generally do not exceed one year, and they are underwritten
      as
      stringently as any commercial loan and generally are of a performance
      nature.





Commercial
      business loans are often larger and may involve greater risk than other types
      of
      lending. Because payments on such loans are often dependent on successful
      operation of the business involved, repayment of such loans may be subject
      to a
      greater extent to adverse conditions in the economy. The Bank seeks to minimize
      these risks through its underwriting guidelines, which require that the loan
      be
      supported by adequate cash flow of the borrower, profitability of the business,
      collateral and personal guarantees of the individuals in the business. In
      addition, the Bank limits this type of lending to its market area and to
      borrowers with which it has prior experience or who are otherwise well known
      to
      the Bank.


8





*Consumer
      Lending.* In
      recent years, the Bank has also focused on originating consumer loans. The
      consumer loans originated by the Bank include automobile loans, certificate
      of
      deposit loans, home equity loans and miscellaneous other consumer loans,
      including unsecured loans. At December 31, 2007, consumer loans totaled $104.4
      million, or 12.5% of the Company’s gross loan portfolio.





The
      Bank’s automobile loans are generally underwritten in amounts up to 90% of the
      lesser of the purchase price of the automobile or, with respect to used
      automobiles, the resale value as published by the National Automobile Dealers
      Association. The terms of most such loans do not exceed 60 months. The Bank
      requires that the vehicles be insured and the Bank be listed as loss payee
      on
      the insurance policy.





The
      Bank
      makes certificate of deposit loans for up to 100% of the depositor’s account
      balance. The interest rate is normally 2% above the annual percentage yield
      paid
      on the account and the account must be pledged as collateral to secure the
      loan.
      Interest generally is billed on a quarterly basis. At December 31, 2007, loans
      on certificates of deposit totaled $1.2 million, or 0.2% of the Company’s gross
      loan portfolio.





At
      December 31, 2007, the Company had approximately $43.6 million in home equity
      line of credit loans, representing approximately 5.2% of its gross loan
      portfolio. The Company’s home equity lines of credit have adjustable interest
      rates tied to the prime interest rate plus a margin. The home equity lines
      of
      credit require monthly payments until the loan is paid in full. Home equity
      lines of credit are generally secured by subordinate liens against residential
      real property. The Bank requires that fire and extended coverage casualty
      insurance (and, if appropriate, flood insurance) be maintained in an amount
      at
      least sufficient to cover its loan. Home equity loans are generally limited
      so
      that the amount of such loans, along with any senior indebtedness, does not
      exceed 85% of the value of the real estate security.





Consumer
      lending affords the Company the opportunity to earn yields higher than those
      obtainable on single-family residential lending. However, consumer loans entail
      greater risk than do residential mortgage loans, particularly in the case of
      loans which are unsecured (as is the case with credit card loans) or secured
      by
      rapidly depreciable assets such as automobiles. Repossessed collateral for
      a
      defaulted consumer loan may not provide an adequate source of repayment of
      the
      outstanding loan balance as a result of the greater likelihood of damage, loss
      or depreciation. The remaining deficiency often does not warrant further
      substantial collection efforts against the borrower. In addition, consumer
      and
      credit card loan collections are dependent on the borrower’s continuing
      financial stability, and thus are more likely to be adversely affected by events
      such as job loss, divorce, illness or personal bankruptcy. Further, the
      application of various state and federal laws, including federal and state
      bankruptcy and insolvency law, may limit the amount which may be recovered.
      In
      underwriting consumer loans, the Bank considers the borrower’s credit history,
      an analysis of the borrower’s income and ability to repay the loan, and the
      value of the collateral.





*Loan
      Fees and Servicing* .
      The
      Bank receives fees in connection with late payments and for miscellaneous
      services related to its loans. The Bank also charges fees in connection with
      loan originations. These fees can consist of origination, discount, construction
      and/or commitment fees, depending on the type of loan. The Bank generally does
      not service loans for others except as set forth below and except for mortgage
      loans originated and sold by the Bank with servicing retained.





In
      addition, the Bank has developed a program to originate loans for a local credit
      union. The Bank receives a 1% origination fee for each loan as well as an annual
      servicing fee of 0.375% of the loan amount. All of these loans are funded and
      closed in the name of the credit union. The Bank has explored the possibility
      of
      developing similar arrangements with other institutions, although none are
      currently planned.





*Nonperforming
      Loans and Other Problem Assets* .
      It is
      management’s policy to continually monitor its loan portfolio to anticipate and
      address potential and actual delinquencies. When a borrower fails to make a
      payment on a loan, the Bank takes immediate steps to have the delinquency cured
      and the loan restored to current status. Loans which are delinquent more than
      15
      days incur a late fee of 4% on mortgage and consumer loans and up to 6% on
      commercial loans of the monthly payment of principal and interest due. As a
      matter of policy, the Bank will contact the borrower after the loan has been
      delinquent 15 days. If payment is not promptly received, the borrower is
      contacted again, and efforts are made to formulate an affirmative plan to cure
      the delinquency. Generally, after any loan is delinquent 45 days or more, a
      default letter is sent to the borrower. If the default is not cured after 30
      days from the default letter, formal legal proceedings are commenced to collect
      amounts owed.


9





Loans
      generally are placed on nonaccrual status, and accrued but unpaid interest
      is
      reversed, when, in management’s judgment, it is determined that the
      collectibility of interest, but not necessarily principal, is doubtful.
      Generally, this occurs when payment is delinquent in excess of 90 days. Consumer
      loans that have become more than 180 days past due are generally charged off,
      or
      a specific allowance may be provided for any expected loss. All other loans
      are
      charged off when management concludes that they are uncollectible. See Notes
      1
      and 4 of Notes to Consolidated Financial Statements in the 2007 Annual Report
      filed as Exhibit 13 hereto.





Real
      estate acquired by the Bank as a result of foreclosure is classified as real
      estate acquired through foreclosure until such time as it is sold and is
      recorded at the lower of the estimated fair value (less estimated costs to
      sell)
      of the underlying real estate or the carrying amount of the loan. Costs relating
      to holding or improving such real estate are charged against income in the
      current period. Any required write-down of the loan to its fair value less
      estimated selling costs upon foreclosure is charged against the allowance for
      loan and lease losses. See Note 4 of Notes to Consolidated Financial
      Statements in the 2007 Annual Report filed as Exhibit 13 hereto.





The
      following table sets forth information with respect to the Bank’s nonperforming
      assets at the dates indicated. At the dates shown, the Bank had no restructured
      loans within the meaning of Statement of Financial Accounting Standards No.
      15.





At December 31,2007
            
            2006
            
            2005
            
            2004
            
            2003(Dollars in thousands)Loans
                accounted for on a nonaccrual basis:Residential
                mortgage:Single-family
            
            $
            798
            
            $
            934
            
            $
            1,362
            
            $
            814
            
            $
            1,057Commercial
                real estate
            
            
            6,588
            
            
            1,274
            
            
            555
            
            
            1,241
            
            
            1,334Commercial
                business
            
            
            26
            
            
            79
            
            
            220
            
            
            49
            
            
            19Consumer
            
            
            143
            
            
            453
            
            
            122
            
            
            245
            
            
            215Total
                nonperforming loans
            
            $
            7,555
            
            $
            2,740
            
            $
            2,259
            
            $
            2,349
            
            $
            2,625Percentage
                of total loans, net
            
            
            0.99
            %
            
            0.36
            %
            
            0.32
            %
            
            0.37
            %
            
            0.47
            %Real
                estate owned
            
            $
            1,602
            
            $
            634
            
            $
            14
            
            $
            89
            
            $
            131





During
      the year ended December 31, 2007, additional gross interest income of
      approximately $505,990 would have been recorded on loans accounted for on a
      nonaccrual basis if the loans had been current throughout this period.





At
      December 31, 2007, the Bank had no loans not classified as nonaccrual, over
      90
      days past due or restructured loans where known information about possible
      credit problems of borrowers caused management to have serious concerns as
      to
      the ability of the borrowers to comply with present loan repayment terms and
      may
      result in disclosure as nonaccrual, over 90 days past due or restructured.





There
      were no loans accruing interest which were contractually over 90 days past
      due
      at the end of any reported period.





At
      December 31, 2007, an analysis of the Bank’s portfolio did not reveal any
      impaired loans that needed to be classified under SFAS No. 114 or 118. 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
      and
      interest when due according to the contractual terms of the loan arrangement.
      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. The 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 payments status,
      borrowers’ financial data and borrowers’ operating factors such as cash flows,
      operating income or loss, and various other matters.




At
        December 31, 2007, the Company had $7.6 million of nonaccrual loans, which
        consisted of 11 single-family residential real estate loans totaling $798,000,
        11 commercial real estate loans totaling $6.6 million, one commercial business
        loan totaling $26,000 and three consumer loans totaling $143,000.


10





At
      December 31, 2007, the Bank had $1.6 million of real estate owned, which
      consisted of five single-family residences and one commercial property.





*Classified
      Assets.* Federal
      regulations require that the Bank classify its assets on a regular basis. In
      addition, in connection with examinations of insured institutions, examiners
      have authority to identify problem assets and if appropriate, classify them
      in
      their reports of examination. There are four classifications for problem assets:
      “special mention,” “substandard,” “doubtful” and “loss.” Special mention assets
      contain some weakness as defined under the substandard category, but do not
      contain the risk level associated with an adverse classification. Special
      mention assets are noted for a watch list to indicate that a potential weakness
      or risk exists, which could cause a more serious problem if not corrected.
      Substandard assets have one or more defined weaknesses and are characterized
      by
      the distinct possibility that the insured institution will sustain some loss
      if
      the deficiencies are not corrected. Doubtful assets have the weaknesses of
      substandard assets with the additional characteristic that the weaknesses make
      collection or liquidation in full, on the basis of currently existing facts,
      conditions and values, questionable, and there is a high possibility of loss.
      An
      asset classified loss is considered uncollectible and of such little value
      that
      continuance as an asset of the institution is not warranted. Assets classified
      as substandard or doubtful require a bank to establish general allowances for
      loan losses. If an asset or portion thereof is classified loss, a bank must
      either establish a specific allowance for loss in the amount of the portion
      of
      the asset classified loss, or charge off such amount. The Bank regularly reviews
      its assets to determine whether any assets require classification or
      re-classification. At December 31, 2007, the Company had $44.2 million in
      classified assets, including $30.6 million in assets classified as special
      mention, $12.7 million in assets classified as substandard, no loans classified
      as doubtful and $870,000 in assets classified as loss, compared to $24.6 million
      in classified assets, including $14.7 million in assets classified as special
      mention, $9.5 million in assets classified as substandard, $1,000 in assets
      classified as doubtful and $423,000 in assets classified as loss at December
      31,
      2006.





*Allowance
      for Loan and Lease Losses and Unfunded Loan Commitments.* The Bank
      maintains both general and specific allowances for loan and lease losses and
      an
      allowance for unfunded loan commitments at levels the Bank believes are adequate
      to absorb probable losses inherent in the loan and lease portfolio and in
      unfunded loan commitments. The Bank has developed policies and procedures for
      assessing the adequacy of the allowance for loan and lease losses and unfunded
      loan commitments that reflect the assessment of credit risk. This assessment
      includes an analysis of qualitative and quantitative trends in the levels of
      classified loans. In developing this analysis, the Bank relies on estimates
      and
      exercises judgment in assessing credit risk. Future assessments of credit risk
      may yield different results, depending on changes in the qualitative and
      quantitative trends, which may require increases or decreases in the allowance
      for loan and lease losses and unfunded loan commitments.





The
      Bank
      uses a variety of modeling and estimation tools for measuring its credit risk,
      which are used in developing the allowance for loan and lease losses and
      unfunded loan commitments. The factors supporting the allowances for loan and
      lease losses and unfunded loan commitments do no diminish the fact that the
      entire allowances for loan and lease losses and unfunded loan commitments are
      available to absorb losses in the loan and leases portfolio and the unfunded
      loan commitment portfolio, respectively. The Bank’s principal focus is on the
      adequacy of the total allowances for loan and lease losses and unfunded loan
      commitments.





Based
      on
      the overall credit quality of the loan and lease receivable portfolio, the
      Bank
      believes the current level of its allowance for loans is adequate. However,
      future additions to the allowance for losses may be necessary based on changes
      in economic conditions and other factors.


11


Activity
      in the allowance for credit losses, which includes the allowance for loan and
      lease losses and unfunded loan commitments, is summarized as
      follows:





Allowance for Loan
              and Lease Losses
            
            Allowance for
              Unfunded Loan
              Commitments
            
            Allowance for
              Credit Losses(Dollar
                in thousands)Balance
                at December 31, 2002
            
            $
            6,959
            
            $
            —
            
            $
            6,959Provision
                for credit losses
            
            
            988
            
            
            —
            
            
            988Loans
                and Leases charged-off
            
            
            (358
            )
            
            —
            
            
            (358
            )Loans
                and Leases recovered
            
            
            45
            
            
            —
            
            
            45Net
                (charge-offs)/recoveries
            
            
            (313
            )
            
            —
            
            
            (313
            )Balance
                at December 31, 2003
            
            
            7,634
            
            
            —
            
            
            7,634Balance
                at December 31, 2003
            
            
            7,634
            
            
            —
            
            
            7,634Provision
                for credit losses
            
            
            968
            
            
            —
            
            
            968Loans
                and Leases charged-off
            
            
            (302
            )
            
            —
            
            
            (302
            )Loans
                and Leases recovered
            
            
            43
            
            
            —
            
            
            43Net
                (charge-offs)/recoveries
            
            
            (259
            )
            
            —
            
            
            (259
            )Balance
                at December 31, 2004
            
            
            8,343
            
            
            —
            
            
            8,343Balance
                at December 31, 2004
            
            
            8,343
            
            
            —
            
            
            8,343Provision
                for credit losses
            
            
            602
            
            
            1,109
            
            
            1,711Loans
                and Leases charged-off
            
            
            (848
            )
            
            —
            
            
            (848
            )Loans
                and Leases recovered
            
            
            16
            
            
            —
            
            
            16Net
                (charge-offs)/recoveries
            
            
            (832
            )
            
            —
            
            
            (832
            )Balance
                at December 31, 2005
            
            
            8,113
            
            
            1,109
            
            
            9,222Balance
                at December 31, 2005
            
            
            8,113
            
            
            1,109
            
            
            9,222Provisions
                for credit losses
            
            
            1,277
            
            
            (344
            )
            
            933Loans
                and Leases charged-off
            
            
            (342
            )
            
            —
            
            
            (342
            )Loans
                and Leases recovered
            
            
            110
            
            
            —
            
            
            110Net
                (charge-offs)/recoveries
            
            
            (232
            )
            
            —
            
            
            (232
            )Balance
                at December 31, 2006
            
            
            9,158
            
            
            765
            
            
            9,923Balance
                at December 31, 2006
            
            
            9,158
            
            
            765
            
            
            9,923Provisions
                for credit losses
            
            
            712
            
            
            (362
            )
            
            350Loans
                and Leases charged-off
            
            
            (421
            )
            
            
            
            
            (421
            )Loans
                and Leases recovered
            
            
            37
            
            
            
            
            
            37Net
                (charge-offs)/recoveries
            
            
            (384
            )
            
            
            
            
            (384
            )Balance
                at December 31, 2007
            
            $
            9,486
            
            $
            403
            
            $
            9,889




12


The
      following table allocates the allowance for credit losses by loan category
      at
      the dates indicated. The allocation of the allowance to each category
      i s
      not
      necessarily indicative of future losses and does not restrict the use of the
      allowance to absorb losses in any category.





At December 31,2007
            
            2006
            
            2005
            
            2004
            
            2003Amount
            
            Percent of
              Loans in
              Category
              to Total
              Loans
            
            Amount
            
            Percent of
              Loans in
              Category
              to Total
              Loans
            
            Amount
            
            Percent of
              Loans in
              Category
              to Total
              Loans
            
            Amount
            
            Percent of
              Loans in
              Category
              to Total
              Loans
            
            Amount
            
            Percent of
              Loans in
              Category
              to Total
              Loans(Dollars in thousands)Allowance
                for Loan and Lease Losses:Residential
                mortgage
            
            $
            510
            
            
            6.7
            %
            $
            510
            
            
            9.5
            %
            $
            510
            
            
            9.7
            %
            $
            1,034
            
            
            11.3
            %
            $
            1,034
            
            
            13.1
            %Commercial
                (1)(2)
            
            
            7,694
            
            
            80.8
            
            
            7,309
            
            
            77.6
            
            
            6,279
            
            
            77.7
            
            
            6,362
            
            
            74.6
            
            
            5,487
            
            
            71.9Consumer
                (3)
            
            
            1,282
            
            
            12.5
            
            
            1,339
            
            
            12.9
            
            
            1,324
            
            
            12.6
            
            
            947
            
            
            14.1
            
            
            1,113
            
            
            15.0Total
                allowance for loan and lease losses
            
            $
            9,486
            
            
            100.0
            %
            $
            9,158
            
            
            100.0
            %
            $
            8,113
            
            
            100.0
            %
            $
            8,343
            
            
            100.0
            %
            $
            7,634
            
            
            100.0
            %Allowance
                for Unfunded Loan Commitments:Mortgage
            
            $
            0
            
            
            0.0
            %
            $
            20
            
            
            2.6
            %
            $
            57
            
            
            5.1
            %Commercial
            
            
            163
            
            
            40.4
            
            
            431
            
            
            56.4
            
            
            684
            
            
            61.7Consumer
            
            
            240
            
            
            59.6
            
            
            314
            
            
            41.0
            
            
            368
            
            
            33.2Total
                allowance for unfunded loan commitments
            
            $
            403
            
            
            100.0
            %
            $
            765
            
            
            100.0
            %
            $
            1,109
            
            
            100.0
            %Combined
                total allowance for credit losses
            
            $
            9,889
            
            
            
            
            $
            9,923
            
            
            
            
            $
            9,222








(1)
            Includes
                commercial real estate, commercial business loans and lease
                receivables.


(2)
            Includes
                $840,000 of specific allowance for loan losses on 12 commercial business
                loans.


(3)
            Includes
                $30,000 of specific allowance for loan losses on two consumer
                loans.




13




**Investment
      Activities**





*General* .
      Interest income from mortgage-backed securities and investment securities
      generally provides the second largest source of income to the Company after
      interest on loans. The Bank’s Board of Directors has authorized investment in
      U.S. Government and agency securities, state government obligations, municipal
      securities, obligations of the Federal Home Loan Bank (“FHLB”) and
      mortgage-backed securities. The Bank’s objective is to use such investments to
      reduce interest rate risk, enhance yields on assets and provide liquidity.
      At
      December 31, 2007, the Company’s mortgage-backed securities and investment
      securities portfolio amounted to $39.1 million and $49.1 million, respectively.
      At such date, the Company had an unrealized gain of $377,000, net of deferred
      taxes, with respect to its securities.





Investment
      and aggregate investment limitations and credit quality parameters of each
      class
      of investment are prescribed in the Bank’s investment policy. The Bank performs
      analyses on mortgage-backed securities and investment securities prior to
      forming mortgage pools and on an ongoing basis to determine the impact on
      earnings and market value under various interest rate and prepayment conditions.
      Securities purchases are subject to the oversight of the Bank’s Investment
      Committee consisting of four directors and are reviewed by the Board of
      Directors on a monthly basis. The Bank’s President has authority to make
      specific investment decisions within the parameters determined by the Board
      of
      Directors.





*Mortgage-Backed
      Securities* .
      At
      December 31, 2007, the Company’s mortgage-backed securities amounted to $39.1
      million, or 4.3% of total assets. Mortgage-backed securities represent a
      participation interest in a pool of single-family or multi-family mortgages,
      the
      principal and interest payments on which are passed from the mortgage
      originators through intermediaries that pool and repackage the participation
      interest in the form of securities to investors such as the Bank. Such
      intermediaries may include quasi-governmental agencies such as FHLMC, FNMA
      and
      GNMA which guarantee the payment of principal and interest to investors.
      Mortgage-backed securities generally increase the quality of the Bank’s assets
      by virtue of the guarantees that back them, are more liquid than individual
      mortgage loans and may be used to collateralize borrowings or other obligations
      of the Bank. At December 31, 2007, all of the Company’s mortgage-backed
      securities were backed by loans originated by the Bank and swapped with the
      FHLMC in exchange for such mortgage-backed securities.





The
      FHLMC
      is a public corporation chartered by the U.S. Government. The FHLMC issues
      participation certificates backed principally by conventional mortgage loans.
      The FHLMC guarantees the timely payment of interest and the ultimate return
      of
      principal on participation certificates. FHLMC securities are not backed by
      the
      full faith and credit of the United States, however, these securities are
      considered to be among the highest quality investments with minimal credit
      risks. The maximum loan limit for FNMA and FHLMC currently is
      $417,000.





Mortgage-backed
      securities typically are issued with stated principal amounts, and the
      securities are backed by pools of mortgages that have loans with interest rates
      that are within a range and having varying maturities. The underlying pool
      of
      mortgages can be composed of either fixed-rate or adjustable-rate loans. As
      a
      result, the risk characteristics of the underlying pool of mortgages,
      ( *i.e.* ,
      fixed-rate or adjustable-rate) as well as prepayment risk, are passed on to
      the
      certificate holder. The life of a mortgage-backed pass-through security thus
      approximates the life of the underlying mortgages.





Mortgage-backed
      securities generally yield less than the loans which underlie such securities
      because of their payment guarantees or credit enhancements which offer nominal
      credit risk. In addition, mortgage-backed securities are more liquid than
      individual mortgage loans and may be used to collateralize borrowings of the
      Bank in the event that the Bank determined to utilize borrowings as a source
      of
      funds. Mortgage-backed securities issued or guaranteed by the FHLMC (except
      interest-only securities or the residual interests in CMOs) are weighted at
      no
      more than 20% for risk-based capital purposes, compared to a weight of 50%
      to
      100% for residential loans. See “Depository Institution Regulation —
Capital Requirements.”





At
      December 31, 2007, mortgage-backed securities with an amortized cost of $37.8
      million and a carrying value of $37.8 million were held as available for sale,
      and mortgage-backed securities with an amortized cost of $1.3 million and a
      carrying value of $1.3 million were held for investment. Mortgage-backed
      securities which are held to maturity are carried at cost, adjusted for the
      amortization of premiums and the accretion of discounts using a method which
      approximates a level yield. Mortgage-backed securities classified as available
      for sale are carried at fair value. Unrealized gains and losses on available
      for
      sale mortgage-backed securities are recognized as direct increases or decreases
      in equity, net of applicable income taxes. At December 31, 2007, the Bank’s
      mortgage-backed securities had a weighted average yield of 5.55%. See Notes
      1, 2
      and 3 of the Notes to Consolidated Financial Statements in the 2007 Annual
      Report filed as Exhibit 13 hereto.


14





At
      December 31, 2007, the average contractual maturity of the Company’s fixed-rate
      mortgage-backed securities available-for-sale was approximately 25.6 years,
      while the average contractual maturity of mortgage-backed securities held for
      investment was approximately 5.7 years. The actual maturity of a mortgage-backed
      security varies, depending on when the mortgagors prepay or repay the underlying
      mortgages. Prepayments of the underlying mortgages may shorten the life of
      the
      investment, thereby adversely affecting its yield to maturity and the related
      market value of the mortgage-backed security. The yield is based upon the
      interest income and the amortization of the premium or accretion of the discount
      related to the mortgage-backed security. Premiums and discounts on
      mortgage-backed securities are amortized or accreted over the estimated term
      of
      the securities using a level yield method. The prepayment assumptions used
      to
      determine the amortization period for premiums and discounts can significantly
      affect the yield of the mortgage-backed security, and these assumptions are
      reviewed periodically to reflect the actual prepayment. The actual prepayments
      of the underlying mortgages depend on many factors, including the type of
      mortgage, the coupon rate, the age of the mortgages, the geographical location
      of the underlying real estate collateralizing the mortgages and general levels
      of market interest rates. The difference between the interest rates on the
      underlying mortgages and the prevailing mortgage interest rates is an important
      determinant in the rate of prepayments. During periods of falling mortgage
      interest rates, prepayments generally increase, and, conversely, during periods
      of rising mortgage interest rates, prepayments generally decrease. If the coupon
      rate of the underlying mortgage significantly exceeds the prevailing market
      interest rates offered for mortgage loans, refinancing generally increases
      and
      accelerates the prepayment of the underlying mortgages. Prepayment experience
      is
      more difficult to estimate for adjustable-rate mortgage-backed
      securities.





*Investment
      Securities* .
      The
      Company’s investment securities consist primarily of securities issued by the
      U.S. government and government agencies. At December 31, 2007, the Company’s
      entire portfolio of investment securities was classified available for sale
      and
      amounted to $48.7 million. The Company attempts to maintain a high degree of
      liquidity in its investment securities portfolio by choosing those that are
      readily marketable. As of December 31, 2007, the estimated average life of
      the
      Company’s investment securities portfolio was approximately 1.7 years. In
      addition, at December 31, 2007, the Company had $3.2 million of FHLB
      stock.





*Equity
      Securities.* The
      Company’s equity securities consist of shares of restricted common stock of
      Triangle Capital Corporation (NASDAQ: TCAP) that it received during 2007 upon
      completion the public offering of TCAP. Prior to the public offering, the
      Company was a 2.2% limited partner in the Triangle Mezzanine Fund, LLLP, with
      a
      limited investment of $500,000. In the public offering, TCAP acquired the
      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.





TCAP
      is a
      specialty finance company organized to provide customized financing solutions
      to
      lower middle market companies located throughout the United States, with an
      emphasis on the Southeast. At December 31, 2007, the TCAP equity securities
      owned by the Company had a market value of approximately $413,000.





The
      following table sets forth the carrying value of the Company’s investment,
      mortgage-backed, and equity securities portfolio at the dates
      indicated.





At December 31,2007
            
            2006
            
            2005(In thousands)Securities
              available for sale:U.S.
                government and agency securities
            
            $
            48,651
            
            $
            56,454
            
            $
            41,827Mortgage-backed
                securities
            
            
            37,828
            
            
            35,067
            
            
            20,639Equity
                securities
            
            
            413
            
            
            —
            
            
            —Total
            
            $
            86,892
            
            $
            91,521
            
            $
            62,466Securities
              held to maturity:FHLB
                stock
            
            $
            3,210
            
            $
            1,933
            
            $
            1,689Mortgage-backed
                securities
            
            
            1,292
            
            
            1,663
            
            
            2,063Total
            
            $
            4,502
            
            $
            3,596
            
            $
            3,752




15




The
      following table sets forth the scheduled maturities, carrying values, amortized
      cost and average yields for the Company’s investment securities and
      mortgage-backed securities portfolio at December 31, 2007.





One Year or Less
            
            One to Five Years
            
            Five to Ten Years
            
            More than Ten Years
            
            Total Investment PortfolioCarrying
              Value
            
            Average
              Yield
            
            Carrying
              Value
            
            Average
              Yield
            
            Carrying
              Value
            
            Average
              Yield
            
            Carrying
              Value
            
            Average
              Yield
            
            Carrying
              Value
            
            Amortized
              Cost
            
            Average
              Yield(Dollars in thousands)Securities
                available for sale:U.S.
                government and agency securities
            
            $
            13,023
            
            
            4.14
            %
            $
            35,628
            
            
            4.68
            %
            $
            0
            
            
            0.00
            %
            $
            0
            
            
            0.00
            %
            $
            48,651
            
            $
            47,944
            
            
            4.53
            %Mortgage-backed
                securities
            
            
            16
            
            
            7.00
            
            
            268
            
            
            6.66
            
            
            2,254
            
            
            6.18
            
            
            35,290
            
            
            5.51
            
            
            37,828
            
            
            37,826
            
            
            5.55Securities
                held to maturity:FHLB
                stock (1)
            
            
            0
            
            
            0.00
            
            
            0
            
            
            0.00
            
            
            0
            
            
            0.00
            
            
            3,210
            
            
            6.00
            
            
            3,210
            
            
            3,210
            
            
            6.00Mortgaged-backed
                securities
            
            
            0
            
            
            0.00
            
            
            0
            
            
            0.00
            
            
            1,292
            
            
            4.00
            
            
            0
            
            
            0.00
            
            
            1,292
            
            
            1,292
            
            
            4.00Equity
                securities
            
            
            413
            
            
            8.64
            
            
            0
            
            
            0.00
            
            
            0
            
            
            0.00
            
            
            0
            
            
            0.00
            
            
            413
            
            
            500
            
            
            8.64Total
            
            $
            13,452
            
            
            4.28
            %
            $
            35,896
            
            
            4.69
            %
            $
            3,546
            
            
            5.39
            %
            $
            38,500
            
            
            5.55
            %
            $
            91,394
            
            $
            90,772
            
            
            5.01
            %




_______________


(1)  As
      a
      member of the FHLB of Atlanta, the Bank is required to maintain an investment
      in
      FHLB stock, which has no stated maturity.





16


**Deposit
      Activity and Other Sources of Funds**





*General.* Deposits
      are the primary source of the Bank’s funds for lending, investment activities
      and general operational purposes. In addition to deposits, the Bank derives
      funds from loan principal and interest repayments, maturities of investment
      securities and mortgage-backed securities and interest payments thereon.
      Although loan repayments are a relatively stable source of funds, deposit
      inflows and outflows are significantly influenced by general interest rates
      and
      money market conditions. Borrowings may be used on a short-term basis to
      compensate for reductions in the availability of funds, or on a longer term
      basis for general operational purposes. The Bank has access to borrowings from
      the FHLB of Atlanta.





*Deposits.* The Bank
      attracts deposits principally from within its market area by offering a variety
      of deposit instruments, including checking accounts, money market accounts,
      statement savings accounts, Individual Retirement Accounts, and certificates
      of
      deposit which range in maturity from seven days to five years. Deposit terms
      vary according to the length of time the funds must remain on deposit and the
      interest rate. Maturities, terms, service fees and withdrawal penalties for
      its
      deposit accounts are established by the Bank on a periodic basis. The Bank
      reviews its deposit pricing on a weekly basis or more frequently based on market
      conditions. In determining the characteristics of its deposit accounts, the
      Bank
      considers the rates offered by competing institutions, lending and liquidity
      requirements, growth goals and federal regulations. Management believes it
      prices its deposits comparably to rates offered by its competitors. The Bank
      does not accept brokered deposits.





The
      Bank
      attempts to compete for deposits with other institutions in its market area
      by
      offering competitively priced deposit instruments that are tailored to the
      needs
      of its customers. Additionally, the Bank seeks to meet customers’ needs by
      providing convenient customer service to the community, efficient staff and
      convenient hours of service. Substantially, all of the Bank’s depositors are
      North Carolina residents. To provide additional convenience, the Bank
      participates in the Cirrus and STAR Automatic Teller Machine networks at
      locations throughout the United States, through which customers can gain access
      to their accounts at any time. To better serve its customers, the Bank has
      installed automatic teller machines at twenty-six office locations.





The
      following tables set forth the distribution of the Bank’s deposit accounts and
      corresponding weighted average interest rates. Management does not believe
      that
      the use of year-end balances instead of average balances resulted in any
      material difference in the information presented.




At December 31,2007
            
            2006
            
            2005Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate
            
            Amount
            
            Weighted
              Average
              Rate(Dollars in thousands)Demand
                accounts:Checking
            
            $
            227,601
            
            
            0.97
            %
            $
            239,251
            
            
            1.03
            %
            $
            223,358
            
            
            0.45
            %Money
                market
            
            
            16,047
            
            
            2.22
            
            
            25,471
            
            
            2.65
            
            
            21,521
            
            
            1.35Savings
                accounts
            
            
            17,498
            
            
            0.15
            
            
            18,481
            
            
            0.15
            
            
            21,510
            
            
            0.15Total
            
            $
            261,146
            
            
            0.99
            %
            $
            283,203
            
            
            1.12
            %
            $
            266,389
            
            
            0.50
            %Certificate
                accounts:Less
                than 12 months (1)
            
            $
            225,839
            
            
            4.58
            %
            $
            264,386
            
            
            4.97
            %
            $
            64,456
            
            
            3.21
            %12-14
                months (1)
            
            
            227,626
            
            
            4.94
            
            
            170,786
            
            
            4.82
            
            
            203,127
            
            
            3.8715-72
                months (1)
            
            
            46,759
            
            
            4.30
            
            
            81,813
            
            
            4.11
            
            
            199,781
            
            
            3.47Total
            
            
            500,224
            
            
            4.72
            
            
            516,985
            
            
            4.78
            
            
            467,364
            
            
            3.61Total
                deposits
            
            $
            761,370
            
            
            3.44
            %
            $
            800,188
            
            
            3.48
            %
            $
            733,753
            
            
            2.48
            %





(1)
            Original
                term.




17


The
      following table indicates the amount of the Company’s certificates of deposit of
      $100,000 or more by time remaining until maturity as of December 31, 2007.
      At
      such date, such deposits represented 26.9% of total deposits and had a weighted
      average rate of 4.89%.





Maturity Period
            
            
            (In thousands)Three
                months or less
            
            
            $
            875Over
                three months
            
            
            
            3,614Over
                six through 12 months
            
            
            
            133,074Over
                12 months
            
            
            
            66,947Total
            
            
            $
            204,510





At
      December 31, 2007, U.S. Agency Bonds with an amortized cost of $14.7 million
      were pledged as collateral for deposits from public entities and repurchase
      agreements.





*Borrowings.* Deposits
      historically have been the primary source of funds for the Bank’s lending,
      investment and general operating activities. The Bank is authorized, however,
      to
      use advances from the FHLB of Atlanta to supplement its supply of lendable
      funds
      and to meet deposit withdrawal requirements. The FHLB of Atlanta functions
      as a
      central reserve bank providing credit for savings institutions and certain
      other
      member financial institutions. As a member of the FHLB System, the Bank is
      required to own stock in the FHLB of Atlanta and is authorized to apply for
      advances. Advances are pursuant to several different programs, each of which
      has
      its own interest rate and range of maturities. The FHLB capital stock
      requirement is based on the sum of a membership stock component totaling 0.20%
      of the Bank’s total assets plus an activity-based stock component of 4.5% of
      outstanding FHLB advances. Advances from the FHLB of Atlanta are secured by
      the
      Bank’s stock in the FHLB of Atlanta and other eligible assets. During the years
      ended December 31, 2007, 2006 and 2005, the Bank’s borrowings consisted of FHLB
      advances and retail repurchase agreements. Retail repurchase agreements
      represent agreements to sell securities under terms which require the Bank
      to
      repurchase the same or substantially similar securities by a specified
      date.





The
      following table sets forth certain information regarding short-term borrowings
      by the Company at the dates and for the periods indicated:





At or for the Year Ended December 31,2007
            
            2006
            
            2005(In thousands)Amounts
                outstanding at end of periods:FHLB
                advances
            
            $
            35,000
            
            $
            6,000
            
            $
            5,500Federal
                funds purchased and securities sold underrepurchase
                agreements
            
            
            7,067
            
            
            5,140
            
            
            6,288Rate
                paid on:FHLB
                advances
            
            
            4.40
            %
            
            5.50
            %
            
            4.44
            %Federal
                funds purchased and securities sold underagreement
                to repurchase
            
            
            3.38
            %
            
            4.86
            %
            
            3.59
            %Maximum
                amount of borrowings outstanding at any month end:FHLB
                advances
            
            
            40,800
            
            
            31,600
            
            
            24,500Federal
                funds purchased and securities sold underrepurchase
                agreements
            
            
            9,198
            
            
            8,556
            
            
            7,012Approximate
                average short-term borrowings outstandingwith
                respect to:FHLB
                advances
            
            
            9,155
            
            
            11,969
            
            
            4,068Federal
                funds purchased and securities sold underrepurchase
                agreements
            
            
            7,221
            
            
            6,625
            
            
            6,182Approximate
                weighted average rate paid on: (1)FHLB
                advances
            
            
            5.01
            %
            
            5.27
            %
            
            2.97
            %Federal
                funds purchased and securities sold underrepurchase
                agreements
            
            
            4.34
            %
            
            4.41
            %
            
            2.71
            %







(1)  Based
      on
      month-end balances.




18






**Competition**





The
      Company faces strong competition in originating real estate, commercial business
      and consumer loans and in attracting deposits. The Bank competes for real estate
      and other loans principally on the basis of interest rates, the types of loans
      it originates, the deposit products it offers and the quality of services it
      provides to borrowers. The Bank also competes by offering products which are
      tailored to the local community. Its competition in originating real estate
      loans comes primarily from other commercial banks, savings institutions,
      mortgage bankers and mortgage brokers. Commercial banks, credit unions and
      finance companies provide vigorous competition in consumer lending. Competition
      may increase as a result of the recent reduction of restrictions on the
      interstate operations of financial institutions.





The
      Bank
      attracts its deposits through its branch offices primarily from the local
      communities. Consequently, competition for deposits is principally from other
      commercial banks, savings institutions, credit unions and brokers in the Bank’s
      primary market area. The Bank competes for deposits and loans by offering what
      it believes to be a variety of deposit accounts at competitive rates, convenient
      business hours, a commitment to outstanding customer service and a well-trained
      staff. The Bank believes it has developed strong relationships with local
      realtors and the community in general.





Management
      considers its primary market area for gathering deposits and/or originating
      loans to be central, eastern, northeastern and southeastern North Carolina,
      where the Bank’s offices are located. The Bank originates loans throughout
      eastern North Carolina.





**Employees**





As
      of
      December 31, 2007, the Bank had 272 full-time and 31 part-time employees, none
      of whom were represented by a collective bargaining agreement. Management
      considers the Bank’s relationships with its employees to be good.





**Depository
      Institution Regulation**





*General.* The Bank
      is a North Carolina chartered commercial bank and its deposit accounts are
      insured by the Deposit Insurance Fund (“DIF”) administered by the Federal
      Deposit Insurance Corporation (“FDIC”). The Bank is subject to supervision,
      examination and regulation by the Commissioner and the FDIC and to North
      Carolina and federal statutory and regulatory provisions governing such matters
      as capital standards, mergers, subsidiary investments and establishment of
      branch offices. The FDIC also has the authority to conduct special examinations.
      The Bank is required to file reports with the Commissioner and the FDIC
      concerning its activities and financial condition and will be required to obtain
      regulatory approval prior to entering into certain transactions, including
      mergers with, or acquisitions of, other depository institutions.





As
      a
      federally insured depository institution, the Bank is subject to various
      regulations promulgated by the Board of Governors of the Federal Reserve System
      (“Federal Reserve Board”), including Regulation B (Equal Credit Opportunity),
      Regulation D (Reserve Requirements), Regulations E (Electronic Fund Transfers),
      Regulation Z (Truth in Lending), Regulation CC (Availability of Funds and
      Collection of Checks) and Regulation DD (Truth in Savings).





The
      system of regulation and supervision applicable to the Bank establishes a
      comprehensive framework for the operations of the Bank, and is intended
      primarily for the protection of the FDIC and the depositors of the Bank. Changes
      in the regulatory framework could have a material effect on the Bank that in
      turn, could have a material effect on the Company. Certain of the legal and
      regulatory requirements applicable to the Bank and Company. The discussion
      does
      not purport to be a complete explanation of all such laws and regulations and
      is
      qualified in its entirety by reference to the statutes and regulations
      involved.





*Capital
      Requirements* .
      The
      Federal Reserve Board and the FDIC have established guidelines with respect
      to
      the maintenance of appropriate levels of capital by bank holding companies
      with
      consolidated assets of $150 million or more and state nonmember banks,
      respectively. The regulations impose two sets of capital adequacy requirements:
      minimum leverage rules, which require bank holding companies and state nonmember
      banks to maintain a specified minimum ratio of capital to total assets, and
      risk-based capital rules, which require the maintenance of specified minimum
      ratios of capital to “risk-weighted” assets. The regulations of the FDIC and the
      Federal Reserve Board require bank holding companies and state nonmember banks,
      respectively, to maintain a minimum leverage ratio of “Tier 1 capital” to total
      assets of 3.0%. Although setting a minimum 3.0% leverage ratio, the capital
      regulations state that only the strongest bank holding companies and banks,
      with
      composite examination ratings of 1 CAMELS under the rating system used by the
      federal bank regulators, are permitted to operate at or near such minimum level
      of capital. All other bank holding companies and banks must maintain a leverage
      ratio of at least 4%. Tier 1 capital is the sum of common stockholders’ equity,
      noncumulative perpetual preferred stock (including any related surplus), and
      minority interests in consolidated subsidiaries; minus all intangible assets
      (other than certain purchased mortgage servicing rights and credit card
      receivables), identified losses and certain investments.




19




As
      a
      DIF-insured, state chartered bank, the Bank must also deduct from Tier 1 capital
      an amount equal to its investments in, and extensions of credit to, subsidiaries
      engaged in activities that are not permissible for national banks, other than
      debt and equity investments in subsidiaries engaged in activities undertaken
      as
      agent for customers or in mortgage banking activities or in subsidiary
      depository institutions or their holding companies. Any bank or bank holding
      company experiencing or anticipating significant growth is expected to maintain
      capital well above the minimum levels. In addition, the Federal Reserve Board
      has indicated that whenever appropriate, and in particular when a bank holding
      company is undertaking expansion, seeking to engage in new activities or
      otherwise facing unusual or abnormal risks, it will consider, on a case-by-case
      basis, the level of an organization’s ratio of tangible Tier 1 capital to total
      assets in making an overall assessment of capital.





In
      addition to the leverage ratio, the regulations of the Federal Reserve Board
      and
      the FDIC require bank holding companies and state chartered nonmember banks
      to
      maintain a minimum ratio of qualifying total capital to risk-weighted assets
      of
      at least 8.0% of which at least 4.0% must be Tier 1 capital. Qualifying total
      capital consists of Tier 1 capital plus Tier 2 or “supplementary capital” items
      which include allowances for loan losses in an amount of up to 1.25% of
      risk-weighted assets, cumulative preferred stock and preferred stock with a
      maturity of 20 years or more, certain other capital instruments and up to 45%
      of
      unrealized gains on equity securities. The includible amount of Tier 2 capital
      cannot exceed the institution’s Tier 1 capital. Qualifying total capital is
      further reduced by the amount of the bank’s investments in banking and finance
      subsidiaries that are not consolidated for regulatory capital purposes,
      reciprocal cross-holdings of capital securities issued by other banks and
      certain other deductions. The risk-based capital regulations assign balance
      sheet assets and the credit equivalent amounts of certain off-balance sheet
      items to one of four broad risk weight categories ranging from 0% to 100%.
      The
      aggregate dollar amount of each category is multiplied by the risk weight
      assigned to that category based principally on the degree of credit risk
      associated with the obligor. The sum of these weighted values equals the bank
      holding company or the bank’s risk-weighted assets.





In
      addition to FDIC regulatory capital requirements, the North Carolina Bank
      Commissioner requires that the Bank have adequate capitalization based upon
      each
      Bank’s particular set of circumstances. The Bank is subject to the
      Commissioner’s capital surplus regulation which requires commercial banks to
      maintain a capital surplus of at least 50% of common capital. Common capital
      is
      defined as the total of the par value of shares times the number of shares
      outstanding.





*Prompt
      Corrective Regulatory Action.* Under
      FDICIA, the federal banking regulators are required to take prompt corrective
      action if an insured depository institution fails to satisfy certain minimum
      capital requirements, including a leverage limit, a risk-based capital
      requirement, and any other measure deemed appropriate by the federal banking
      regulators for measuring the capital adequacy of an insured depository
      institution. All institutions, regardless of their capital levels, are
      restricted from making any capital distribution or paying any management fees
      if
      the institution would thereafter fail to satisfy the minimum levels for any
      of
      its capital requirements. An institution that fails to meet the minimum level
      for any relevant capital measure (an “undercapitalized institution”) may be: (i)
      subject to increased monitoring by the appropriate federal banking regulator;
      (ii) required to submit an acceptable capital restoration plan within 45 days;
      (iii) subject to asset growth limits; and (iv) required to obtain prior
      regulatory approval for acquisitions, branching and new lines of businesses.
      The
      capital restoration plan must include a guarantee by the institution’s holding
      company that the institution will comply with the plan until it has been
      adequately capitalized on average for four consecutive quarters, under which
      the
      holding company would be liable up to the lesser of 5% of the institution’s
      total assets or the amount necessary to bring the institution into capital
      compliance as of the date it failed to comply with its capital restoration
      plan.
      A “significantly undercapitalized” institution, as well as any undercapitalized
      institution that does not submit an acceptable capital restoration plan, may
      be
      subject to regulatory demands for recapitalization, broader application of
      restrictions on transactions with affiliates, limitations on interest rates
      paid
      on deposits, asset growth and other activities, possible replacement of
      directors and officers, and restrictions on capital distributions by any bank
      holding company controlling the institution. Any company controlling the
      institution may also be required to divest the institution or the institution
      could be required to divest subsidiaries. The senior executive officers of
      a
      significantly undercapitalized institution may not receive bonuses or increases
      in compensation without prior approval and the institution is prohibited from
      making payments of principal or interest on its subordinated debt. In their
      discretion, the federal banking regulators may also impose the foregoing
      sanctions on an undercapitalized institution if the regulators determine that
      such actions are necessary to carry out the purposes of the prompt corrective
      provisions. If an institution’s ratio of tangible capital to total assets falls
      below the “critical capital level” established by the appropriate federal
      banking regulator, the institution will be subject to conservatorship or
      receivership within specified time periods.




20




Under
      the
      implementing regulations, the federal banking regulators, including the FDIC,
      generally measure an institution’s capital adequacy on the basis of its total
      risk-based capital ratio (the ratio of its total capital to risk-weighted
      assets), Tier 1 risk-based capital ratio (the ratio of its core capital to
      risk-weighted assets) and leverage ratio (the ratio of its core capital to
      adjusted total assets). The following table shows the capital ratios required
      for the various prompt corrective action categories.





Adequately
            
            SignificantlyWell
                Capitalized
            
            Capitalized
            
            Undercapitalized
            
            UndercapitalizedTotal
                risk-basedcapital
                ratio
            
            10.0%
                or more
            
            8.0%
                or more
            
            Less
                than 8.0%
            
            Less
                than 6.0%Tier
                1 risk-basedcapital
                ratio
            
            6.0%
                or more
            
            4.0%
                or more
            
            Less
                than 4.0%
            
            Less
                than 3.0%Leverage
                ratio
            
            5.0%
                or more
            
            4.0%
                or more *
            
            Less
                than 4.0% *
            
            Less
                than 3.0%





*
      3.0% if
      institution has a composite 1 CAMELS rating.





A
      “critically undercapitalized” institution is defined as an institution that has
      a ratio of “tangible equity” to total assets of less than 2.0%. Tangible equity
      is defined as core capital plus cumulative perpetual preferred stock (and
      related surplus) less all intangibles other than qualifying supervisory goodwill
      and certain purchased mortgage servicing rights. The FDIC may reclassify a
      well
      capitalized institution as adequately capitalized and may require an adequately
      capitalized or undercapitalized institution to comply with the supervisory
      actions applicable to institutions in the next lower capital category (but
      may
      not reclassify a significantly undercapitalized institution as critically
      undercapitalized) if the FDIC determines, after notice and an opportunity for
      a
      hearing, that the institution is in an unsafe or unsound condition or that
      the
      institution has received and not corrected a less-than-satisfactory rating
      for
      any CAMELS rating category.





*Safety
      and Soundness Guidelines.* Under
      FDICIA, as amended by the Riegle Community Development and Regulatory
      Improvement Act of 1994 (the “CDRI Act”), each federal banking agency was
      required to establish safety and soundness standards for institutions under
      its
      authority. The interagency guidelines require depository institutions to
      maintain internal controls and information systems and internal audit systems
      that are appropriate for the size, nature and scope of the institution’s
      business. The guidelines also establish certain basic standards for loan
      documentation, credit underwriting, interest rate risk exposure, asset growth
      and information security. The guidelines further provide that depository
      institutions should maintain safeguards to prevent the payment of compensation,
      fees and benefits that are excessive or that could lead to material financial
      loss, and should take into account factors such as comparable compensation
      practices at comparable institutions. If the appropriate federal banking agency
      determines that a depository institution is not in compliance with the safety
      and soundness guidelines, it may require the institution to submit an acceptable
      plan to achieve compliance with the guidelines. A depository institution must
      submit an acceptable compliance plan to its primary federal regulator within
      30
      days of receipt of a request for such a plan. Failure to submit or implement
      a
      compliance plan may subject the institution to regulatory sanctions. Management
      believes that the Bank substantially meets all the standards adopted in the
      interagency guidelines.





*Community
      Reinvestment Act.* The
      Bank, like other financial institutions, is subject to the Community
      Reinvestment Act (“CRA”). The purpose of the CRA is to encourage financial
      institutions to help meet the credit needs of their entire communities,
      including the needs of low-and moderate-income neighborhoods.




21




The
      federal banking agencies have implemented an evaluation system that rates an
      institution based on its actual performance in meeting community credit needs.
      Under these regulations, an institution is first evaluated and rated under
      three
      categories: a lending test, an investment test and a service test. For each
      of
      these three tests, the institution is given a rating of either “outstanding,”
“high satisfactory,” “low satisfactory,” “needs to improve,” or “substantial
      non-compliance.” A set of criteria for each rating has been developed and is
      included in the regulation. If an institution disagrees with a particular
      rating, the institution has the burden of rebutting the presumption by clearly
      establishing that the quantitative measures do not accurately present its actual
      performance, or that demographics, competitive conditions or economic or legal
      limitations peculiar to its service area should be considered. The ratings
      received under the three tests will be used to determine the overall composite
      CRA rating. The composite ratings currently given are: “outstanding,”
“satisfactory,” “needs to improve” or “substantial non-compliance.”





The
      Bank’s CRA rating would be a factor to be considered by the Federal Reserve
      Board and the FDIC in considering applications submitted by the Bank to acquire
      branches or to acquire or combine with other financial institutions and take
      other actions and, if such rating was less than “satisfactory,” could result in
      the denial of such applications. During the Bank’s last compliance examination,
      the Bank received an outstanding rating with respect to CRA
      compliance.





*Federal
      Home Loan Bank System.* The FHLB
      System consists of 12 district FHLBs subject to supervision and regulation
      by
      the Federal Housing Finance Board (“FHFB”). The FHLBs provide a central credit
      facility primarily for member institutions. As a member of the FHLB of Atlanta,
      the Bank is required to acquire and hold shares of capital stock in the FHLB
      of
      Atlanta. The Bank was in compliance with this requirement with investment in
      FHLB of Atlanta stock at December 31, 2007, of $3.2 million. The FHLB of Atlanta
      serves as a reserve or central bank for its member institutions within its
      assigned district. It is funded primarily from proceeds derived from the sale
      of
      consolidated obligations of the FHLB System. It offers advances to members
      in
      accordance with policies and procedures established by the FHFB and the Board
      of
      Directors of the FHLB of Atlanta. Long-term advances may only be made for the
      purpose of providing funds for residential housing finance, small businesses,
      small farms and small agribusinesses.





*Reserves.* Pursuant
      to regulations of the Federal Reserve Board, the Bank must maintain average
      daily reserves equal to 3% on transaction accounts of $8.5 million up to $45.8
      million, plus 10% on the remainder. This percentage is subject to adjustment
      by
      the Federal Reserve Board. Because required reserves must be maintained in
      the
      form of vault cash or in a noninterest bearing account at a Federal Reserve
      Bank, the effect of the reserve requirement is to reduce the amount of the
      institution’s interest-earning assets. As of December 31, 2007, the Bank met its
      reserve requirements.





The
      Bank
      is also subject to the reserve requirements of North Carolina commercial banks.
      North Carolina law requires state nonmember banks to maintain, at all times,
      a
      reserve fund in an amount set by the State Banking Commission.





*Insurance
      of Deposit Accounts.* The
      Bank’s deposits are insured up to applicable limits by the Deposit Insurance
      Fund of the FDIC. The Deposit Insurance Fund is the successor to the Bank
      Insurance Fund and the Savings Association Insurance Fund, which were merged
      in
      2006. The FDIC recently amended its risk-based assessment system for 2007 to
      implement authority granted by the Federal Deposit Insurance Reform Act of
      2005
      (“Reform Act”). Under the revised system, insured institutions are assigned to
      one of four risk categories based on supervisory evaluations, regulatory capital
      levels and certain other factors. An institution’s assessment rate depends upon
      the category to which it is assigned. Risk category I, which contains the least
      risky depository institutions, is expected to include more than 90% of all
      institutions. Unlike the other categories, Risk Category I contains further
      risk
      differentiation based on the FDIC’s analysis of financial ratios, examination
      component ratings and other information. Assessment rates are determined by
      the
      FDIC and currently range from five to seven basis points for the healthiest
      institutions (Risk Category I) to 43 basis points of assessable deposits for
      the
      riskiest (Risk Category IV). The FDIC may adjust rates uniformly from one
      quarter to the next, except that no single adjustment can exceed three basis
      points. No institution may pay a dividend if in default of the FDIC
      assessment.





The
      Reform Act also provided for a one-time credit for eligible institutions based
      on their assessment base as of December 31, 1996. Subject to certain limitations
      with respect to institutions that are exhibiting weaknesses, credits can be
      used
      to offset assessments until exhausted. The Bank’s one-time assessment credit was
      $405,964. The Reform Act also provided for the possibility that the FDIC may
      pay
      dividends to insured institutions once the Deposit Insurance fund reserve ratio
      equals or exceeds 1.35% of estimated insured deposits.




22




In
      addition to the assessment for deposit insurance, institutions are required
      to
      make payments on bonds issued in the late 1980s by the Financing Corporation
      to
      recapitalize a predecessor deposit insurance fund. This payment is established
      quarterly and during the calendar year ended December 31, 2007 averaged 1.18
      basis points of assessable deposits.





The
      Reform Act provided the FDIC with authority to adjust the Deposit Insurance
      Fund
      ratio to insured deposits within a range of 1.15% and 1.50%, in contrast to
      the
      prior statutorily fixed ratio of 1.25%. The ratio, which is viewed by the FDIC
      as the level that the fund should achieve, was established by the agency at
      1.25% for 2008, which was unchanged from 2007.





The
      FDIC
      has authority to increase insurance assessments. A significant increase in
      insurance premiums would likely have an adverse effect on the operating expenses
      and results of operations of the Bank. Management cannot predict what insurance
      assessment rates will be in the future.





Insurance
      of deposits may be terminated by the FDIC upon a finding that the institution
      has engaged in unsafe or unsound practices, is in an unsafe or unsound condition
      to continue operations or has violated any applicable law, regulation, rule,
      order or condition imposed by the FDIC. The management of the Bank does not
      know
      of any practice, condition or violation that might lead to termination of
      deposit insurance.





*Liquidity
      Requirements* .
      FDIC
      policy requires that banks maintain an average daily balance of liquid assets
      (cash, certain time deposits, mortgage-backed securities, loans available for
      sale and specified United States government, state, or federal agency
      obligations) in an amount which it deems adequate to protect safety and
      soundness of the bank. The FDIC currently has no specific level which it
      requires. Under the FDIC’s calculation method, management calculated the Bank’s
      liquidity ratio as 14% of total deposits at December 31, 2007, which management
      believes is adequate.





*Dividend
      Restrictions.* 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%.





Earnings
      of the Bank appropriated to bad debt reserves and deducted for federal income
      tax purposes are not available for payment of cash dividends or other
      distributions to stockholders without payment of taxes at the then current
      tax
      rate by the Bank on the amount of earnings removed from the pre-1988 reserves
      for such distributions. The Bank intends to make full use of this favorable
      tax
      treatment and does not contemplate use of any earnings in a manner which would
      create federal tax liabilities.





*Limits
      on Loans to One Borrower.* The Bank
      generally is subject to both FDIC regulations and North Carolina law regarding
      loans to any one borrower, including related entities. Under applicable law,
      with certain limited exceptions, loans and extensions of credit by a state
      chartered nonmember bank to a person outstanding at one time and not fully
      secured by collateral having a market value at least equal to the amount of
      the
      loan or extension of credit shall not exceed 15% of the unimpaired capital
      of
      the Bank. Loans and extensions of credit fully secured by readily marketable
      collateral having a market value shall not exceed 10% of the unimpaired capital
      fund of the Bank. Under these limits, the Bank’s loans to one borrower were
      limited to $14.3 million at December 31, 2007. At that date, the Bank had no
      lending relationships in excess of the loans-to-one-borrower limit.
      Notwithstanding the statutory loans-to-one-borrower limitations, the Bank has
      a
      self imposed loans-to-one-borrower limit, which currently is $7.2 million,
      which
      it has exceeded from time to time as approved in advance by the Board of
      Directors. At December 31, 2007, the Bank’s largest lending relationship was a
      $9.4 million relationship consisting of 14 commercial real estate loans, two
      commercial business loans and one consumer loan. All loans within this
      relationship were current and performing in accordance with their terms at
      December 31, 2007.





*Transactions
      with Related Parties.* Transactions between a state nonmember bank and any affiliate are governed
      by
      Sections 23A and 23B of the Federal Reserve Act. An affiliate of a state
      nonmember bank is any company or entity which controls, is controlled by or
      is
      under common control with the state nonmember bank. In a holding company
      context, the parent holding company of a state nonmember bank (such as the
      Company) and any companies which are controlled by such parent holding company
      are affiliates of the savings institution or state nonmember bank. Generally,
      Sections 23A and 23B (i) limit the extent to which an institution or its
      subsidiaries may engage in “covered transactions” with any one affiliate to an
      amount equal to 10% of such institution’s capital stock and surplus, and contain
      an aggregate limit on all such transactions with all affiliates to an amount
      equal to 20% of such capital stock and surplus and (ii) require that all such
      transactions be on terms substantially the same, or at least as favorable,
      to
      the institution or subsidiary as those provided to a non-affiliate. The term
      “covered transaction” includes the making of loans, purchase of assets, issuance
      of a guarantee and similar other types of transactions.




23




*Loans
      to Directors, Executive Officers and Principal Stockholders.* State
      nonmember banks also are subject to the restrictions contained in Section 22(h)
      of the Federal Reserve Act and the applicable regulations thereunder on loans
      to
      executive officers, directors and principal stockholders. Under Section 22(h),
      loans to a director, executive officer and to a greater than 10% stockholder
      of
      a state nonmember bank and certain affiliated interests of such persons, may
      not
      exceed, together with all other outstanding loans to such person and affiliated
      interests, the institution’s loans-to-one-borrower limit and all loans to such
      persons may not exceed the institution’s unimpaired capital and unimpaired
      surplus. Section 22(h) also prohibits loans, above amounts prescribed by the
      appropriate federal banking agency, to directors, executive officers and greater
      than 10% stockholders of a depository institution, and their respective
      affiliates, unless such loan is approved in advance by a majority of the board
      of directors of the institution with any “interested” director not participating
      in the voting. Regulation O prescribes the loan amount (which includes all
      other
      outstanding loans to such person) as to which such prior board of director
      approval is required as being the greater of $25,000 or 5% of capital and
      surplus (or any loans aggregating $500,000 or more). Further, Section 22(h)
      requires that loans to directors, executive officers and principal stockholders
      generally be made on terms substantially the same as offered in comparable
      transactions to other persons. Section 22(h) also generally prohibits a
      depository institution from paying the overdrafts of any of its executive
      officers or directors.





State
      nonmember banks also are subject to the requirements and restrictions of Section
      22(g) of the Federal Reserve Act on loans to executive officers. Section 22(g)
      of the Federal Reserve Act requires approval by the board of directors of a
      depository institution for such extensions of credit and imposes reporting
      requirements for and additional restrictions on the type, amount and terms
      of
      credits to such officers. In addition, Section 106 of the BHCA prohibits
      extensions of credit to executive officers, directors, and greater than 10%
      stockholders of a depository institution by any other institution which has
      a
      correspondent banking relationship with the institution, unless such extension
      of credit is on substantially the same terms as those prevailing at the time
      for
      comparable transactions with other persons and does not involve more than the
      normal risk of repayment or present other unfavorable features.





Additionally,
      North Carolina statutes set forth restrictions on loans to executive officers
      of
      state chartered banks, which provide that no bank may extend credit to any
      of
      its executive officers nor a firm or partnership of which such executive
      officers is a member, nor a company in which such executive officer owns a
      controlling interest, unless the extension of credit is made on substantially
      the same terms, including interest rates and collateral, as those prevailing
      at
      the time for comparable transactions by the bank with persons who are not
      employed by the bank, and provided further that the extension of credit does
      not
      involve more than the normal risk of repayment.





*Restrictions
      on Certain Activities* .
      State
      chartered nonmember banks with deposits insured by the FDIC are generally
      prohibited from engaging in equity investments that are not permissible for
      a
      national bank. The foregoing limitation, however, does not prohibit FDIC-insured
      state banks from acquiring or retaining an equity investment in a subsidiary
      in
      which the bank is a majority owner. State chartered banks are also prohibited
      from engaging as a principal in any type of activity that is not permissible
      for
      a national bank and, subject to certain exceptions, subsidiaries of state
      chartered FDIC-insured state banks may not engage as a principal in any type
      of
      activity that is not permissible for a subsidiary of a national bank, unless
      in
      either case, the FDIC determines that the activity would pose no significant
      risk to the appropriate deposit insurance fund and the bank is, and continues
      to
      be, in compliance with applicable capital standards.





*Patriot
      Act.* The
      Patriot Act is intended to strengthen U.S. law enforcement’s and the
      intelligence communities’ abilities to work cohesively to combat terrorism on a
      variety of fronts. The potential impact of the Patriot Act on financial
      institutions of all kinds is significant and wide ranging. The Patriot Act
      contained sweeping anti-money laundering and financial transparency laws and
      imposes various regulations including standards for verifying client
      identification at account opening, and rules to promote cooperation among
      financial institutions, regulators and law enforcement entities in identifying
      parties that may be involved in terrorism or money laundering.




24




**Regulation
      of the Company**





*General* .
      The
      Company, as the sole shareholder of the Bank, is a bank holding company and
      is
      registered with the Federal Reserve Board. Bank holding companies are subject
      to
      comprehensive regulation by the Federal Reserve Board under the Bank Holding
      Company Act of 1956, as amended (the “BHCA”), and the regulations of the Federal
      Reserve Board. As a bank holding company, the Company is required to file with
      the Federal Reserve Board annual reports and such additional information as
      the
      Federal Reserve Board may require, and is subject to regular examinations by
      the
      Federal Reserve Board. The Federal Reserve Board also has extensive enforcement
      authority over bank holding companies, including, among other things, the
      ability to assess civil money penalties, to issue cease and desist or removal
      orders and to require that a holding company divest subsidiaries (including
      its
      bank subsidiaries). In general, enforcement actions may be initiated for
      violations of law and regulations and unsafe or unsound practices.





Under
      the
      BHCA, a bank holding company must obtain Federal Reserve Board approval before:
      (i) acquiring, directly or indirectly, ownership or control of any voting shares
      of another bank or bank holding company if, after such acquisition, it would
      own
      or control more than 5% of such shares (unless it already owns or controls
      the
      majority of such shares); (ii) acquiring all or substantially all of the assets
      of another bank or bank holding company; or (iii) merging or consolidating
      with
      another bank holding company. In evaluating applications for acquisitions,
      the
      Federal Reserve Board considers such things as the financial condition and
      management of the target and the acquirer, the convenience and needs of the
      communities involved (including CRA ratings) and competitive
      factors.





The
      BHCA
      also prohibits a bank holding company, with certain exceptions, from acquiring
      direct or indirect ownership or control of more than 5% of the voting shares
      of
      any company which is not a bank or bank holding company, or from engaging
      directly or indirectly in activities other than those of banking, managing
      or
      controlling banks, or providing services for its subsidiaries. The principal
      exceptions to these prohibitions involve certain nonbank activities which,
      by
      statute or by Federal Reserve Board regulation or order, have been identified
      as
      activities closely related to the business of banking or managing or controlling
      banks. The list of activities permitted by the Federal Reserve Board includes,
      among other things, operating a savings institution, mortgage company, finance
      company, credit card company or factoring company; performing certain data
      processing operations; providing certain investment and financial advice;
      underwriting and acting as an insurance agent for certain types of
      credit-related insurance; leasing property on a full-payout, non-operating
      basis; selling money orders, travelers’ checks and United States Savings Bonds;
      real estate and personal property appraising; providing tax planning and
      preparation services; and, subject to certain limitations, providing securities
      brokerage services for customers. The Company has no present plans to engage
      in
      any of these activities.





The
      Gramm-Leach-Bliley Act of 1999 authorized bank holding companies that meet
      specified qualitative standards to opt to become a “financial holding company.”
A financial holding company may engage in activities that are permissible for
      bank holding companies in addition to activities deemed to be financial in
      nature or incidental to financial activities. These include insurance
      underwriting and investment banking. The Company has not up to now opted to
      become a financial holding company.





The
      Federal Reserve Board has adopted guidelines regarding the capital adequacy
      of
      bank holding companies, which require bank holding companies to maintain
      specified minimum ratios of capital to total assets and capital to risk-weighted
      assets. See “— Depository
      Institution Regulation — Capital Requirements.”





*Acquisition
      of Bank Holding Companies and Banks.* Under
      the BHCA, any company must obtain approval of the Federal Reserve Board prior
      to
      acquiring control of the Company or the Bank. For purposes of the BHCA,
“control” is defined as ownership of more than 25% of any class of voting
      securities of the Company or the Bank, the ability to control the election
      of a
      majority of the directors, or the exercise of a controlling influence over
      management or policies of the Company or the Bank. In addition, the Change
      in
      Bank Control Act and the related regulations of the Federal Reserve Board
      require any person or persons acting in concert, to file a written notice with
      the Federal Reserve Board before such person or persons may acquire control
      of
      the Company or the Bank. The Change in Bank Control Act defines “control” as the
      power, directly or indirectly, to vote 25% or more of any voting securities
      or
      to direct the management or policies of a bank holding company or an insured
      bank; however, a rebuttable presumption of control exists upon the acquisition
      of power to vote 10% or more of a class of voting securities for a company,
      such
      as the Company, whose securities are registered under the Securities Exchange
      Act of 1934.




25




*Interstate
      Banking.* Federal
      law allows the Federal Reserve Board to approve an application of an adequately
      capitalized and adequately managed bank holding company to acquire control
      of,
      or acquire all or substantially all of the assets of, a bank located in a state
      other than the holding company’s home state, without regard to whether the
      transaction is prohibited by the laws of any state. The Federal Reserve Board
      may not approve the acquisition of a bank that has not been in existence for
      a
      minimum of five years without regard for a longer minimum period specified
      by
      the law of the host state. The Federal Reserve Board is prohibited from
      approving an application if the applicant (and its depository institution
      affiliates) controls or would control (i) more than 10% of the insured deposits
      in the United States, or (ii) 30% or more of the deposits in the target bank’s
      home state or in any state in which the target bank maintains a branch. Federal
      law does not limit a state’s authority to restrict the percentage of total
      insured deposits in the state which may be held or controlled by a bank or
      bank
      holding company to the extent such limitation does not discriminate against
      out-of-state banks or bank holding companies. Individual states may also waive
      the 30% state-wide concentration limit.





Additionally,
      the federal banking agencies are authorized to approve interstate merger
      transactions without regard to whether such transaction is prohibited by the
      law
      of any state, unless the home state of one of the banks has adopted a law opting
      out of the interstate mergers. Interstate acquisitions of branches are permitted
      only if the law of the state in which the branch is located permits such
      acquisitions. Interstate mergers and branch acquisitions are subject to the
      nationwide and statewide insured deposit concentration amounts described above.
      North Carolina has enacted legislation permitting interstate banking
      acquisitions.





Federal
      law authorizes the FDIC to approve interstate branching de novo by state banks
      only in states which specifically allow for such branching. The appropriate
      federal banking agencies adopted regulations which prohibit any out-of-state
      bank from using the interstate branching authority primarily for the purpose
      of
      deposit production. These regulations include guidelines to ensure that
      interstate branches operated by an out-of-state bank in a host state are
      reasonably helping to meet the credit needs of the communities which they
      serve.





*Dividends.* The
      Federal Reserve Board has issued a policy statement on the payment of cash
      dividends by bank holding companies, which expresses the Federal Reserve Board’s
      view that a bank holding company should pay cash dividends only to the extent
      that the company’s net income for the past year is sufficient to cover both the
      cash dividends and a rate of earnings retention that is consistent with the
      company’s capital needs, asset quality and overall financial condition. The
      Federal Reserve Board also indicated that it would be inappropriate for a
      company experiencing serious financial problems to borrow funds to pay
      dividends. Furthermore, under the prompt corrective action regulations adopted
      by the Federal Reserve Board, 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”. See “— Depository Institution
      Regulation — Prompt Corrective Regulatory Action.”





Bank
      holding companies are required to give the Federal Reserve Board prior written
      notice of any purchase or redemption of its outstanding equity securities if
      the
      gross consideration for the purchase or redemption, when combined with the
      net
      consideration paid for all such purchases or redemptions during the preceding
      12
      months, is equal to 10% or more of the their consolidated net worth. The Federal
      Reserve Board may disapprove such a purchase or redemption if it determines
      that
      the proposal would constitute an unsafe or unsound practice or would violate
      any
      law, regulation, Federal Reserve Board order, directive, or any condition
      imposed by, or written agreement with, the Federal Reserve Board. Bank holding
      companies whose capital ratios exceeded the thresholds for well capitalized
      banks on a consolidated basis are exempt from the foregoing requirement if
      they
      were rated CAMELS 1 or 2 in their most recent regulatory inspection and are
      not
      the subject of any unresolved supervisory issues.





**Taxation –
      General**





The
      Company files its federal income tax return based on a fiscal year ending
      December 31.





**Federal
      Income Taxation**





Legislation
      that became effective for tax years beginning after December 31, 1995 requiring
      the Bank to recapture into taxable income over a six taxable year period the
      portion of the tax loan reserve that exceeds the pre-1988 tax loan loss reserve.
      The Bank will no longer be allowed to use the reserve method for tax loan loss
      provisions, but would be allowed to use the experience method of accounting
      for
      bad debts. There will be no future effect on net income from the recapture
      because the taxes on these bad debts reserves has already been accrued as a
      deferred tax liability.





The
      Bank’s federal income tax returns have been audited through the year ended
      September 30, 1992.




26


**State
      Income Taxation**





Under
      North Carolina law, the corporate income tax currently is 6.90% of federal
      taxable income as computed under the Internal Revenue Code, subject to certain
      prescribed adjustments. An annual state franchise tax is imposed at a rate
      of
      .15% applied to the greatest of the institutions (i) capital stock, surplus
      and
      undivided profits, (ii) investment in tangible property in North Carolina or
      (iii) appraised valuation of property in North Carolina.





For
      additional information regarding taxation, see Notes 1 and 10 of Notes to
      Consolidated Financial Statements in the 2007 Annual Report filed as Exhibit
      13
      hereto.





**Item
      1A. Risk Factors**





**Certain
      interest rate movements may impact earnings and asset
      value.**





Since
      December 31, 2006, the prime lending rate has decreased from 8.25% to 7.25%
      at
      December 31, 2007. Short-term and intermediate-term market interest rates are
      used as a guide to price the Bank’s loans and deposits. The recent decrease in
      such interest rates has had a negative impact on the Bank’s interest rate spread
      and net interest margin to date, as a result of the interest sensitivity of
      the
      Bank’s interest-earning assets. Should short-term interest rates decline
      dramatically in the near future, and if rates on the Bank’s loans and
      investments reprice downwards faster than the rates on the Bank’s deposits and
      borrowings, the Bank could experience more compression of its interest rate
      spread and net interest margin, which could have a negative effect on the Bank’s
      profitability.





Changes
      in interest rates also affect the value of the Bank’s interest-earning assets,
      and in particular the Bank’s securities portfolio. Generally, the value of
      fixed-rate securities fluctuates inversely with changes in interest rates.
      Unrealized gains and losses on securities available for sale are reported as
      a
      separate component of equity, net of tax. Decreases in the fair value of
      securities available for sale resulting from increases in interest rates could
      have an adverse effect on stockholders’ equity.





**Strong
      competition within the Bank’s market area could hurt profits and slow
      growth.**





The
      Bank
      faces intense competition both in making loans and attracting deposits. This
      competition makes it more difficult for the Bank to make new loans and at times
      has required the Bank to offer higher deposit rates. Price competition for
      loans
      and deposits could result in the Bank earning less on loans and paying more
      on
      deposits, which could reduce net interest income. Competition also makes it
      more
      difficult to grow loans and deposits, and to hire and retain experienced
      employees. Some of the institutions with which the Bank competes have
      substantially greater resources and lending limits than the Bank has and may
      offer services that the Bank does not provide. Management expects competition
      to
      continue in the future as a result of legislative, regulatory and technological
      changes and the continuing trend of consolidation in the financial services
      industry. The Bank’s profitability depends upon its continued ability to compete
      successfully in its market area.





**The
      Company and the Bank operate in a highly regulated environment and may be
      adversely affected by changes in laws and regulations.**





The
      Bank
      is subject to extensive regulation, supervision and examination by the North
      Carolina Commissioner of Banks and the FDIC, as its primary federal regulator.
      The Company also is subject to regulation and supervision by the Board of
      Governors of the Federal Reserve System and by the Commissioner. Such regulation
      and supervision govern the activities in which an institution and its holding
      company may engage, and are intended primarily for the protection of the
      insurance fund and the depositors and borrowers of the Bank rather than for
      holders of the Company’s common stock. Regulatory authorities have extensive
      discretion in their supervisory and enforcement activities, including the
      imposition of restrictions on operations, the classification of the Bank’s
      assets and determination of the level of allowance for loan losses. Any change
      in such regulation and oversight, whether in the form of regulatory policy,
      regulations, legislation or supervisory action, may have a material impact
      on
      operations.




27




**The
      Bank emphasizes commercial real estate, commercial business and consumer
      lending, which generally are riskier than residential mortgage
      lending.**





The
      Bank
      currently operates as a North Carolina chartered commercial bank. Prior to
      its
      conversion to a commercial bank in 1997, the Bank operated as a traditional
      savings and loan association, primarily emphasizing the origination of loans
      secured by single-family residences. Upon converting to a commercial bank,
      the
      Board of Directors determined there was a local demand for commercial real
      estate, commercial business and consumer loans. As a result, the Board of
      Directors determined to refocus the Bank’s strategy. Pursuant to this strategy,
      while continuing to pursue its existing business of originating single-family
      residential mortgage loans, the Bank took advantage of the business
      opportunities identified by the Board of Directors by gradually expanding into
      commercial real estate, commercial business and consumer lending. In furtherance
      of this strategy, the Bank recruited experienced commercial real estate and
      consumer loan and consumer lending officers and developed commercial real
      estate, commercial business and consumer loan products. As a result of these
      efforts over the years, at December 31, 2007, the Company had commercial real
      estate, commercial construction, commercial business and consumer loans totaling
      $436.1 million, $174.6 million, $49.0 million and $104.4 million, respectively,
      which represented 52.3%, 21.0%, 5.9% and 12.5%, respectively, of total loans.
      As
      December 31, 2007, $56.0 million, or 6.7% of total loans, consisted of
      residential real estate mortgage loans.





While
      commercial real estate, commercial business and consumer loans are generally
      more interest rate sensitive and carry higher yields than do residential
      mortgage loans, they generally carry a higher degree of credit risk than
      residential mortgage loans.





Commercial
      real estate lending entails significant additional risks as compared with
      single-family residential property lending. Commercial real estate loans
      typically involve larger loan balances to single borrowers or groups of related
      borrowers. The payment experience on such loans typically is dependent on the
      successful operation of the real estate project, retail establishment or
      business. These risks can be significantly affected by supply and demand
      conditions in the market for office, retail and residential space, and, as
      such,
      may be subject to a greater extent to adverse conditions in the economy
      generally. To minimize these risks, the Bank generally limits itself to its
      market area or to borrowers with which it has prior experience or who are
      otherwise known to the Bank. It has been the Bank’s policy to obtain annual
      financial statements of the business of the borrower or the project for which
      commercial real estate loans are made. In addition, in the case of commercial
      mortgage loans made to a partnership of a corporation, the Bank seeks, whenever
      possible, to obtain personal guarantees and annual financial statements of
      the
      principals of the partnership or corporation.





Commercial
      business loans are often larger and may involve greater risk than other types
      of
      lending. Because payments on such loans are often dependent on successful
      operation of the business involved, repayment of such loans may be subject
      to a
      greater extent to adverse conditions in the economy. The Bank will seek to
      minimize these risks through its underwriting guidelines, which may require
      certain safeguards, such as the loan be supported by adequate cash flow of
      the
      borrower, profitability of the business, collateral and personal guarantees
      of
      the individual in the business. In addition, the Bank generally limits this
      type
      of lending to its market area and to borrowers with whom it has prior experience
      or who are otherwise well known to the Bank.





Consumer
      loans entail greater risk than do residential mortgage loans, particularly
      in
      the case of loans which are unsecured or secured by rapidly depreciable assets.
      Repossessed collateral for a defaulted consumer loan may not provide an adequate
      source of repayment of the outstanding loan balance as a result of the greater
      likelihood of damage, loss or depreciation. The remaining deficiency often
      does
      not warrant further substantial collection efforts against the borrower. In
      addition, consumer loan collections are dependent on the borrower’s continuing
      financial stability, and this are more likely to be adversely affected by events
      such as job loss, divorce, illness or personal bankruptcy. See “Business of the
      Bank — Lending Activities — Consumer and Other Lending.”





**The
      Company’s financial condition and results of operations are dependent on the
      economy in the Bank’s market area.**





The
      Bank’s market area consists of central, eastern, northeastern and southeastern
      North Carolina, where the Bank’s offices are located. As of December 31, 2007,
      management estimates that more than 95% of deposits and 90% of loans came from
      its primary market area. Because of the Bank’s concentration of business
      activities in its primary market area, the Company’s financial condition and
      results of operations depend upon economic conditions in its market
      area.





28




**Provisions
      in the Company’s Certificate of Incorporation and Bylaws and statutory
      provisions could discourage a hostile acquisition of
      control.**





The
      Company’s Certificate of Incorporation and Bylaws contain certain provisions
      that could discourage non-negotiated takeover attempts that certain stockholders
      might deem to be in their interests or through which stockholders might
      otherwise receive a premium for their shares over the then current market price
      and that may tend to perpetuate existing management. These provisions include:
      the classification of the terms of the members of the Board of Directors;
      supermajority provisions for the approval of certain business combinations;
      elimination of cumulative voting by stockholders in the election of directors;
      certain provisions relating to meetings of stockholders; restrictions on the
      acquisition of the Company’s equity securities; and provisions allowing the
      Board of Directors to consider nonmonetary factors in evaluating a business
      combination or a tender or exchange offer. The provisions in the Company’s
      Certificate of Incorporation requiring a supermajority vote for the approval
      of
      certain business combinations and containing restrictions on acquisitions of
      the
      Company’s equity securities provide that the supermajority voting requirements
      or acquisition restrictions do not apply to business combinations or
      acquisitions meeting specified Board of Directors approval requirements. The
      Certificate of Incorporation also authorizes the issuance of 1,000,000 shares
      of
      preferred stock as well as additional shares of Common Stock up to a total
      of
      25,000,000 outstanding shares. These shares could be issued without stockholder
      approval on terms or in circumstances that could deter a future takeover
      attempt.





In
      addition, Virginia law provides for certain restrictions an acquisition of
      the
      Company, and federal and North Carolina laws contain various restrictions on
      acquisitions of control of banks and their holding companies.





The
      Certificate of Incorporation, Bylaws and statutory provisions, as well as
      certain other provisions of state and federal law and certain provisions in
      the
      Company’s and the Bank’s employee benefit plans, employment agreements and
      change in control severance agreements, may have the effect of discouraging
      or
      preventing a future takeover attempt in which stockholders of the Company
      otherwise might receive a substantial premium for their shares over then current
      market prices.





**Item
      1B. Unresolved Staff Comments**





Not
      Applicable.





**Item
      2.**  **Properties**





The
      following table sets forth the location and certain additional information
      regarding the Bank’s offices at December 31, 2007.




Year
                Opened
              
              Owned
                  or
                Leased
              
              Book
                Value
                  at
                December
                31,
                  2007
              
              Approximate
                Square
                Footage(Dollars
                  in thousands)**Main
                  Office:**
                1311
                  Carolina Avenue
                Washington,
                  NC
              
              
              1986
              
              
              Owned
              
              $
              927
              
              
              10,200**Branch
                  Offices:**
                300
                  North Market Street
                Washington,
                  NC
              
              
              1959
              
              
              Owned
              
              
              109
              
              
              4,6801328
                  John Small Avenue
                Washington,
                  NC
              
              
              2001
              
              
              Leased
              
              
              5
              
              
              1,9162999
                  US Hwy. 17S.
                Chocowinity,
                  NC
              
              
              1999
              
              
              **
              
              
              253
              
              
              2,530301
                  E. Arlington Boulevard
                Greenville,
                  NC
              
              
              1993
              
              
              Owned
              
              
              277
              
              
              2,600
  29
  Year
                Opened
              
              Owned
                  or
                Leased
              
              Book
                Value
                  at
                December
                31,
                  2007
              
              Approximate
                Square
                Footage
 907
                  E. Firetower Road
                Greenville,
                  NC
              
              
              2005
              
              
              Owned
              
              
              762
              
              
              2,2451707
                  SE. Greenville Blvd
                Greenville,
                  NC
              
              
              2007
              
              
              Owned
              
              
              1,111
              
              
              2,245604
                  E. Ehringhaus Street
                Elizabeth
                  City, NC
              
              
              1980
              
              
              Owned
              
              
              127
              
              
              2,5001906
                  S. Croatan Street
                Kill
                  Devil Hills, NC
              
              
              2002
              
              
              Leased
              
              
              48
              
              
              2,0003210
                  N. Croatan Street*
                Kill
                  Devil Hills, NC
              
              
              2004
              
              
              Leased
              
              
              5
              
              
              1,50047560
                  Hwy. 12
                Buxton,
                  NC
              
              
              2005
              
              
              **
              
              
              518
              
              
              2,0292430
                  Heritage Street
                Kinston,
                  NC
              
              
              2001
              
              
              Leased
              
              
              26
              
              
              2,1451725
                  Glenburnie Road
                New
                  Bern, NC
              
              
              1990
              
              
              Owned
              
              
              262
              
              
              2,600202
                  Craven Street
                New
                  Bern, NC
              
              
              1995
              
              
              Leased
              
              
              —
              
              
              2,5002019
                  S. Glenburnie Road
                Crossroads
                  Shopping Center
                New
                  Bern, NC
              
              
              2004
              
              
              Leased
              
              
              51
              
              
              43511560
                  NC Hwy 55
                Suite
                  11
                Grantsboro,
                  NC
              
              
              2007
              
              
              Leased
              
              
              93
              
              
              1,600241
                  Green Street
                Fayetteville,
                  NC
              
              
              1999
              
              
              Owned
              
              
              704
              
              
              9,550705
                  Executive Place*
                Fayetteville,
                  NC
              
              
              1999
              
              
              Leased
              
              
              36
              
              
              2,200600
                  N. Chestnut Street
                Lumberton,
                  NC
              
              
              1999
              
              
              Owned
              
              
              314
              
              
              6,0003000
                  N. Elm Street
                Lumberton,
                  NC
              
              
              2001
              
              
              Leased
              
              
              33
              
              
              2,1283103
                  N. Main Street
                Hope
                  Mills, NC
              
              
              2004
              
              
              Owned
              
              
              515
              
              
              2,072904
                  A West Broad St
                Dunn,
                  NC
              
              
              2007
              
              
              Leased
              
              
              17
              
              
              1,477100
                  East Hope Lodge Street
                Tarboro,
                  NC
              
              
              2000
              
              
              Leased
              
              
              10
              
              
              1,350
  30
  Year
                Opened
              
              Owned
                  or
                Leased
              
              Book
                Value
                  at
                December
                31,
                  2007
              
              Approximate
                Square
                Footage
 300
                  Sunset Avenue
                Rocky
                  Mount, NC
              
              
              1994
              
              
              Owned
              
              
              270
              
              
              4,9482901
                  Sunset Avenue
                Rocky
                  Mount, NC
              
              
              2000
              
              
              Owned
              
              
              1,008
              
              
              5,635450
                  North Winstead Avenue
                Rocky
                  Mount, NC
              
              
              2000
              
              
              Leased
              
              
              25
              
              
              2,8451378
                  Benvenue Road
                Rocky
                  Mount, NC
              
              
              2000
              
              
              **
              
              
              285
              
              
              5,3763635
                  North Halifax Road
                Rocky
                  Mount, NC
              
              
              2000
              
              
              Leased
              
              
              27
              
              
              3964800
                  Six Forks Road
                Six
                  Forks III, Suite #115
                Raleigh,
                  NC
              
              
              2004
              
              
              Leased
              
              
              47
              
              
              4,5014215
                  University Dr*
                Durham,
                  NC
              
              
              2004
              
              
              Leased
              
              
              215
              
              
              2,0003804
                  Peachtree Ave
                Unit
                  200
                Wilmington,
                  NC
              
              
              2007
              
              
              Leased
              
              
              33
              
              
              1,200**Credit
                  Administration:**
                Creekside
                  2
                220
                  Creekside Drive
                Washington,
                  NC
              
              
              1994
              
              
              Owned
              
              
              682
              
              
              10,000**Operations
                  Center:**
                Creekside
                  1
                220
                  Creekside Drive
                Washington,
                  NC
              
              
              2001
              
              
              Owned
              
              
              586
              
              
              10,000**First
                  South Leasing, LLC:**
                1035
                  Director Court
                Suite
                  C
                Greenville,
                  NC
              
              
              2001
              
              
              Leased
              
              
              25
              
              
              1,146





*
              Branch
                  was relocated in 2007.**
              Lease
                  land, own building.




The
      book
      value of the Bank’s investment in premises and equipment was $9.4 million at
      December 31, 2007. See Notes 1 and 5 to Consolidated Financial Statements in
      the
      2007 Annual Report filed as Exhibit 13 hereto.




31




**Item
      3. Legal Proceedings**





From
      time
      to time, the Company and/or the Bank is a party to various legal proceedings
      incident to their business. At December 31, 2007, there were no legal
      proceedings to which either the Company or the Bank was a party, or to which
      any
      of their property was subject, which were expected by management to result
      in a
      material loss to the Company or the Bank. There are no pending regulatory
      proceedings to which the Company or the Bank is a party or to which either
      of
      their properties is subject which are currently expected to result in a material
      loss.





**Item
      4.**  **Submission
      of Matters to a Vote of Security Holders**





Not
      applicable.





**PART
      II**





**Item
      5.**  **Market
      for the Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities**





(a)  The
      information contained in the sections captioned “Stockholder Information — Stock
      Listing
      Information” and “— Stock Price Information” in the Company’s Annual Report to
      Stockholders for the Fiscal Year Ended December 31, 2007 (the “Annual Report”)
      filed as Exhibit 13 hereto is incorporated herein by reference.





(b) Not
          applicable.





(c)  The
      following table sets forth information regarding the Company's repurchases
      of
      its common stock during the fourth quarter of the fiscal year covered by this
      Annual Report.





**(a)**
            
            **(b)**
            
            **(c)**
            
            **(d)****Period**
            
            **Total**
              **Number
                of**
              **Shares**
              **Purchased****(1)**
            
            **Average**
              **Price
                Paid**
              **per
                Share**
            
            **Total
                Number of**
              **Shares Purchased**
              **as Part of Publicly**
              **Announced Plans**
              **Programs**
            
            **Maximum**
              **Number of Shares that**
              **May Yet Be Purchased**
              **Under**
              **the Plans or Programs**October
                2007
              Beginning
                date:
              October
                1
              Ending
                date:
              October
                31
            
            
            825
            
            $
            26.18
            
            
            825
            
            
            350,824November
                2007
              Beginning
                date:
              November
                1
              Ending
                date:
              November
                30
            
            
            76,876
            
            
            23.75
            
            
            76,876
            
            
            273,948December
                2007
              Beginning
                date:
              December
                1
              Ending
                date:
              December
                31
            
            
            23,776
            
            
            23.21
            
            
            23,776
            
            
            250,172








(1)  The
      shares were repurchased pursuant to a repurchase program announced on January
      9,
      2007. Under this program, the Company announced that it would repurchase up
      to
      494,370 shares of its Common Stock, as adjusted for a subsequent three-for-two
      stock split. This program expired on January 11, 2008. The Company purchased
      265,696 shares of the 494,370 shares previously approved under that
      plan.





**Item
      6.**  **Selected
      Financial Data**





The
      information contained in the table captioned “Selected Consolidated Financial
      Information and Other Data” on page 4 in the Annual Report is incorporated
      herein by reference.





32




**Item
      7.**  **Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations**





The
      information contained in the section captioned “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations” in the Annual Report
      is incorporated herein by reference as Exhibit 13.





**Item
      7A.**  **Quantitative
      and Qualitative Disclosures About Market Risk**





The
      information contained in the section captioned “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations — Market
      Risk” in
      the Annual Report is incorporated herein by reference as Exhibit
      13.




33




**Item
      8.**  **Financial
      Statements and Supplementary Data**





The
      Report of Independent Auditors, Consolidated Financial Statements, Notes to
      Consolidated Financial Statements and Selected Financial Data contained in
      the
      Annual Report, which are listed under Item 15 herein, are incorporated herein
      by
      reference.





The
      report of Dixon Hughes PLLC with respect to the consolidated statements of
      operations, changes in stockholders’ equity and cash flows of the Company for
      the year ended December 31, 2005 follows.




Logo of DIXON HUGHES PLLC





**Report
      of Independent Registered Public Accounting Firm**





To
      the
      Stockholders and the Board of Directors


First
      South Bancorp, Inc.


Washington,
      North Carolina





We
      have
      audited the accompanying consolidated statements of operations, changes in
      stockholders’ equity and cash flows of First South Bancorp, Inc. and Subsidiary
      (the “Company”) for the year ended December 31, 2005. These consolidated
      financial statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these consolidated financial
      statements based on our audit.





We
      conducted our audit 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 audit provides a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the results of operations and cash flows of First
      South Bancorp, Inc. and Subsidiary for the year ended December 31, 2005 in
      conformity with accounting principles generally accepted in the United States
      of
      America.





As
      discussed in Note 1 to the consolidated financial statements, the Company
      declared, on April 20, 2006, a three for two stock split which was distributed
      on May 25, 2006 in the form of a 50% stock dividend.





Dixon Hughes PLLC


*Greenville,
      North Carolina*


*March
      7, 2006, except as to the stock split discussed in Note 1 to the consolidated
      financial statements which is as of May 25, 2006*




34




**Item
      9.**  **Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosure**





The
      information contained under the section captioned “Relationship with Independent
      Registered Public Accounting Firm” in the Company’s definitive proxy statement
      for the Company’s 2008 Annual Meeting of Stockholders (the “Proxy Statement”) is
      incorporated herein by reference.





**Item
      9A. Controls and Procedures**





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





The
      annual report of management on the effectiveness of internal control over
      financial and the attestation report thereon issued by the Company’s independent
      registered public accounting firm are set forth below under “Management’s Report
      on Internal Control Over Financial Reporting” and “Report of Independent
      Registered Public Accounting Firm”.





**Management’s
      Annual Report on Internal Control Over Financial Reporting**





[Letterhead
      of First South Bancorp, Inc.]





Management
      of First South Bancorp, Inc. and subsidiary (the “Company”) is responsible for
      the preparation, integrity, and fair presentation of its published financial
      statements as of December 31, 2007, and for the year then ended. The
      consolidated financial statements of the Company have been prepared in
      accordance with accounting principles generally accepted in the United States
      of
      America and, as such, include some amounts that are based on judgments and
      estimates of management.





Management
      of the Company is responsible for establishing and maintaining effective
      internal control over financial reporting as defined in Rules 13a-15(f) and
      15d-15(f) under the Securities Exchange Act of 1934. Internal control over
      financial reporting is a process designed to provide reasonable assurance
      regarding the reliability of financial reporting and the preparation of
      financial statements for external purposes in accordance with U.S. generally
      accepted accounting principles.





Under
      the
      supervision and with the participation of management, including the principal
      executive officer and principal financial officer, the Company conducted an
      evaluation of the effectiveness of internal control over financial reporting
      based on the framework in INTERNAL CONTROL—INTEGRATED FRAMEWORK issued by the
      Committee of Sponsoring Organizations of the Treadway Commission. Based on
      this
      evaluation under the framework in INTERNAL CONTROL—INTEGRATED FRAMEWORK,
      management of the Company has concluded the Company maintained effective
      internal control over financial reporting as of December 31, 2007.





Internal
      control over financial reporting cannot provide absolute assurance of achieving
      financial reporting objectives because of its inherent limitations. Internal
      control over financial reporting is a process that involves human diligence
      and
      compliance and is subject to lapses in judgment and breakdowns resulting from
      human failures. Internal control over financial reporting can also be
      circumvented by collusion or improper management override. Because of such
      limitations, there is a risk that material misstatements may not be prevented
      or
      detected on a timely basis by internal control over financial
      reporting.




35




Management
      is also responsible for compliance with laws and regulations relating to safety
      and soundness which are designated by the Federal Deposit Insurance Corporation
      and the appropriate federal banking agency. Management assessed its compliance
      with these designated laws and regulations relating to safety and soundness
      and
      believes that the Company complied, in all significant respects, with such
      laws
      and during the year ended December 31, 2007.





Turlington
      and Company, LLP, an independent, registered public accounting firm, has audited
      the Company’s consolidated financial statements as of and for the year ended
      December 31, 2007, and has issued an attestation report on the Company’s
      assessment of the effectiveness of the Company’s internal control over financial
      reporting as of December 31, 2007, which is included herein.





First
      South Bancorp, Inc.


March
      4,
      2008






/s/
                Thomas A. Vann
            
            
            /s/
                William L. WallThomas
                A. Vann
            
            William
                L. WallPresident
                and Chief Executive Officer
            
            Executive
                Vice President andChief
                Financial Officer




**Attestation
      Report of Independent Registered Public Accounting Firm**





[Letterhead
      of Turlington and Company, LLP]




REPORT
      OF INDEPENDENT REGISTERED PUBLIC
      ACCOUNTING FIRM





To
      the
      Board of Directors and Stockholders


First
      South Bancorp, Inc.


Washington,
      North Carolina





We
      have
      audited First South Bancorp, Inc.'s internal control over financial reporting
      as
      of December 31, 2007, based on criteria established in *Internal
      Control - Integrated Framework* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      First South Bancorp, Inc.'s management is responsible for maintaining effective
      internal control over financial reporting and for its assessment of the
      effectiveness of internal control over financial reporting included in the
      accompanying Management's Annual Report on Internal Control Over Financial
      Reporting. Our responsibility is to express an opinion on the company’s internal
      control over financial reporting based on our audit.





We
      conducted our audit 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 effective
      internal control over financial reporting was maintained in all material
      respects. Our audit of internal control over financial reporting included
      obtaining an understanding of internal control over financial reporting,
      assessing the risk that a material weakness exists, and testing and evaluating
      the design and operating effectiveness of internal control based on the assessed
      risk. Our audit also included performing such other procedures as we considered
      necessary in the circumstances. We believe that our audit provides a reasonable
      basis for our opinion.





A
      company's internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. Because management's assessment
      and our audits were conducted to also meet the requirements of Section 112
      of
      the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management's
      assessment and our audit of the Company's internal control over financial
      reporting included controls over the preparation of financial statements in
      accordance with the Federal Financial Institution's Examination Council
      instructions for Consolidated Reports of Condition and Income ("call report
      instructions"). A company's internal control over financial reporting includes
      those policies and procedures that (1) pertain to the maintenance of records
      that, in reasonable detail, accurately and fairly reflect the transactions
      and
      dispositions of the assets of the company; (2) provide reasonable assurance
      that
      transactions are recorded as necessary to permit preparation of financial
      statements in accordance with generally accepted accounting principles, and
      that
      receipts and expenditures of the company are being made only in accordance
      with
      authorizations of management and directors of the company; and (3) provide
      reasonable assurance regarding prevention or timely detection of unauthorized
      acquisition, use, or disposition of the company's assets that could have a
      material effect on the financial statements.





36





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





In
      our
      opinion, First South Bancorp, Inc. maintained, in all material respects,
      effective internal control over financial reporting as of December 31, 2007,
      based on criteria established in *Internal
      Control – Integrated
      Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO).




We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated statements of financial
      condition and the related consolidated statements of operations, changes in
      stockholders' equity, and cash flows of First South Bancorp, Inc., and our
      report dated March 5, 2008, expressed an unqualified opinion.





We
      do not
      express an opinion or any other form of assurance on management's statement
      referring to compliance with designated laws and regulations related to safety
      and soundness.




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





Lexington,
      North Carolina


March
      5,
      2008




**Changes
      in Internal Control Over Financial Reporting**





There
      have been no changes in the Company’s internal control over financial reporting
      identified in connection with the evaluation required under paragraph (d) of
      Securities and Exchange Commission Rule 13a-15 that occurred during the
      Company’s last fiscal quarter, that has materially affected, or is reasonably
      likely to materially affect, the Company’s internal control over financial
      reporting.




**Item
      9B. Other Information**





Not
      applicable.





**PART
      III**





**Item
      10.**  **Directors
      and Executive Officers of the Registrant**





The
      information contained under the sections captioned “Proposal I — Election
      of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in
      the Proxy Statement is incorporated herein by reference.





The
      Company has adopted a Code of Ethics that applies to the Company’s principal
      executive officer, principal financial officer and principal accounting officer.
      The Company has posted such Code of Ethics on its Internet website and intends
      to satisfy the disclosure requirement under Item 10 of Form 8-K regarding an
      amendment to, or waiver from, the Code of Ethics by posting such information
      on
      its Internet website. The Company’s Internet website may be accessed as follows:
      http://www.firstsouthnc.com.





**Item
      11.**  **Executive
      Compensation**





The
      information contained under the sections captioned “Proposal I — Election
      of Directors,” “— Executive Compensation,” and “— Director Compensation,”
“Compensation Committee Report” and “Compensation Committee Interlocks and
      Insider Participation” in the Proxy Statement is incorporated herein by
      reference.




37




**Item
      12.**  **Security
      Ownership of Certain Beneficial Owners and Management and Related Stockholder
      Matters**





(a)
            **Security
                Ownership of Certain Beneficial Owners.**Information
                required by this item is incorporated herein by reference to the
                section
                captioned “Voting Securities and Security Ownership” in the Proxy
                Statement.





(b)
            **Security
                Ownership of Management.**Information
                required by this item is incorporated herein by reference to the
                sections
                captioned “Voting Securities and Security Ownership” and “Proposal
                I — Election of Directors” in the Proxy
                Statement.





(c)
            **Changes
                in Control.**Management of the Company knows of no arrangements, including any
                pledge
                by any person of securities of the Company, the operation of which
                may at
                a subsequent date result in a change in control of the registrant.





(d)
            **Equity
                Compensation Plans.**The
                following table sets forth certain information with respect to the
                Company’s equity compensation plans as of December 31,
                2007.




**(a)**
              
              **(b)**
              
              **(c)****Number
                  of securities to be**
                **issued
                  upon exercise of**
                **outstanding
                  options,**
                **warrants
                  and rights**
              
              **Weighted-average**
                **exercise**
                **price
                  of outstanding**
                **options,
                  warrants and********rights**
              
              **Number
                  of securities**
                **remaining**
                **available
                  for future issuance**
                **under
                  equity compensation**
                **plans
                  (excluding securities**
                **reflected
                  in column (a))**Equity
                  compensation plans
                approved
                  by security holders
              
              
              255,919
              
              $
              13.90
              
              
              967,652Equity
                  compensation plans not
                approved
                  by security holders
              
              
              —
              
              
              —
              
              
              —Total
              
              
              255,919
              
              $
              13.90
              
              
              967,652




**Item
      13.**  **Certain
      Relationships and Related Transactions**





The
      information required by this item is incorporated herein by reference to the
      section captioned “Proposal I — Election
      of
      Directors — Transactions with Management” in the Proxy
      Statement.





**Item
      14. Principal Accountant Fees and Services**





Information
      required by this item is incorporated herein by reference to the section
      captioned “Audit and Other Fees Paid to Independent Registered Public Accounting
      Firm” in the Proxy Statement.





**PART
      IV**




**Item
      15.**  **Exhibits
      and Financial Statement Schedules**





**(a)** **List
      of Documents Filed as Part of this Report**





**(1)** ***Financial
      Statements*** **.** The
      following consolidated financial statements are incorporated by reference from
      Item 8 hereof:





Reports
      of Independent Registered Public Accounting Firms


Consolidated
      Statements of Financial Condition as of December 31, 2007 and 2006


Consolidated
      Statements of Operations for the Years Ended December 31, 2007, 2006 and
      2005


Consolidated
      Statements of Changes in Stockholder’s Equity for the Years Ended December 31,
      2007, 2006 and 2005


Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2007, 2006 and
      2005


Notes
      to
      Consolidated Financial Statements




38




**(2)** ***Financial
      Statement Schedules.*** All
      schedules for which provision is made in the applicable accounting regulations
      of the Securities and Exchange Commission are omitted because of the absence
      of
      conditions under which they are required or because the required information
      is
      included in the consolidated financial statements and related notes
      thereto.





**(3)** ***Exhibits*** **.** The
      following is a list of exhibits filed as part of this Annual Report on Form
      10-K
      and is also the Exhibit Index.





**No.**
            
            **Description**3.1
            
            
            Certificate
                of Incorporation of First South Bancorp, Inc. (Incorporated herein
                by
                reference from Exhibit 3.1 to the Company’s Registration Statement on Form
                S-1 (File No. 333-16335))3.2
            
            
            Bylaws
                of First South Bancorp, Inc., as amended (Incorporated herein by
                reference
                from the Company’s Annual Report on Form 10-K for the Year Ended December
                31, 2004 (File No. 0-22219))4.1
            
            
            Form
                of Common Stock Certificate of First South Bancorp, Inc. (Incorporated
                herein by reference from Exhibit 1 to the Company’s Registration Statement
                on Form 8-A)4.2
            
            
            Junior
                Subordinated Indenture between First South Bancorp, Inc. and The
                Bank of
                New York dated September 26, 2004 (Incorporated herein by reference
                from
                the Company’s Annual Report on Form 10-K for the Year Ended December 31,
                2003 (File No. 0-22219))10.1
            
            
            Amended
                and Restated Employment Agreement between First South Bancorp, Inc.,
                First
                South Bank and Thomas A. Vann (Incorporated herein by reference from
                the Company’s Quarterly Report on Form 10-Q for the Quarter
                Ended March 31, 2006 (File No. 0-22219))*10.2
            
            
            Change
                in Control Protective Agreements between Home Savings Bank, SSB,
                First
                South Bancorp, Inc. and Mary R. Boyd, Sherry L. Correll and Kristie
                W.
                Hawkins (Incorporated herein by reference from Exhibit 10.4 to the
                Company’s Registration Statement on Form S-1 (File No.
                333-16335))*10.3
            
            
            Supplemental
                Income Agreements as Amended and Restated December 14, 1995 between
                Home
                Savings Bank, SSB and Sherry L. Correll and Thomas A. Vann and the
                1996
                Amendment Thereto (Incorporated herein by reference from Exhibit
                10.5 to
                the Company’s Registration Statement on Form S-1 (File No.
                333-16335))*10.4
            
            
            Supplemental
                Income Plan Agreements as Amended and Restated December 14, 1995
                between
                Home Savings Bank, SSB and  Thomas A. Vann and William L. Wall and
                the 1996 Amendment Thereto (Incorporated herein by reference from
                Exhibit
                10.6 to the Company’s Registration Statement on Form S-1 (File No.
                333-16335))*10.5
            
            
            Director’s
                Deferred Compensation Plan Agreements as Amended and Restated December
                14,
                1995 with Edmund T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick
                N.
                Holscher, Frederick H. Howdy, Charles E. Parker, Jr., Marshall T.
                Singleton and Thomas A. Vann and the 1996 Amendment Thereto (Incorporated
                herein by reference from Exhibit 10.7 to the Company’s Registration
                Statement on Form S-1 (File No. 333-16335))*10.6
            
            
            Director’s
                Retirement Plan Agreements as Amended and Restated December 14, 1995
                with
                Edmund T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher,
                Frederick H. Howdy, Charles E. Parker, Jr. and Thomas A. Vann, the
                1996
                Amendment thereto and the 2003 Amendment thereto (Incorporated herein
                by
                reference from the Company’s Annual Report on Form 10-K for the Year Ended
                December 31, 2003 (File No. 0-22219))*10.7
            
            
            Director’s
                Retirement Payment Agreements as Amended and Restated December 14,
                1995
                with Edmund T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher,
                Frederick H. Howdy, Charles E. Parker, Jr., and Thomas A. Vann and
                the
                1996 Amendment Thereto (Incorporated herein by reference from Exhibit
                10.9
                to the Company’s Registration Statement on Form S-1 (File No.
                333-16335))*




39




10.8
            
            
            Directors
                Retirement Plan Agreement with Marshall Singleton and the 2003 Amendment
                thereto (Incorporated herein by reference from the Company’s Annual Report
                on Form 10-K for the Year Ended December 31, 2003 (File No.
                0-22219))*10.9
            
            
            First
                South Bancorp, Inc. 1997 Stock Option Plan, as amended (Incorporated
                herein by reference from Exhibit 10.10 to the Company’s Annual Report on
                Form 10-K for the Year Ended September 30, 1999 (File No.
                0-22219))*10.10
            
            
            Intentionally
                omitted10.11
            
            
            Change-in-Control
                Protective Agreement between First South Bank, First South Bancorp,
                Inc.
                and Larry W. Mallard dated April 14, 2005 and amended on February
                7, 2007
                (Incorporated herein by reference from the Company’s Annual Report on Form
                10-K for the Year Ended December 31, 2006 (File No.
                0-22219))*10.12
            
            
            Amended
                and Restated Change-in-Control Protective Agreement between First
                South
                Bank, First South Bancorp, Inc. and William L. Wall dated April 20,
                2006
                (Incorporated herein by reference to the Company’s Quarterly Report
                on Form 10-Q for the Quarter Ended March 31, 2006 (File No.
                0-22219))*10.13
            
            
            Trust
                Preferred Securities Guarantee Agreement between First South Bancorp,
                Inc., and The Bank of New York dated September 26, 2003 (Incorporated
                herein by reference from the Company’s Annual Report on Form 10-K for the
                Year Ended December 31, 2003 (File No. 0-22219))13
            
            
            Annual
                Report to Stockholders for the Fiscal Year Ended December 31,
                200721
            
            
            Subsidiaries
                of the Registrant23.1
            
            
            Consent
                of Turlington and Company, LLP23.2
            
            
            Consent
                of Dixon Hughes PLLC31.1
            
            
            Rule
                13a-14(a) Certification of Chief Executive Officer31.2
            
            
            Rule
                13a-14(a) Certification of Chief Financial Officer32
            
            
            Certification
                pursuant to 18 U.S.C. Section 1350





*  Management
      contract or compensatory plan or arrangement.





**(b)**  **Exhibits** **.** The
      exhibits required by Item 601 of Regulation S-K are either filed as part of
      this
      Annual Report on Form 10-K or incorporated by reference herein.





**(c)**  **Financial
      Statements and Schedules Excluded from Annual Report** **.** There
      are no other financial statements and financial statement schedules which were
      excluded from the Annual Report to Stockholders pursuant to Rule 14a-3(b) which
      are required to be included herein.




40




**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.





FIRST
                SOUTH BANCORP, INC.March
                11, 2008By:
            /s/
                Thomas A. VannThomas
                A. VannPresident





Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities and on the dates indicated.








/s/
                Thomas A. Vann
            
            March
                11, 2008Thomas
                A. VannPresident
                and Director(Principal
                Executive Officer)/s/
                William L. Wall
            
            March
                11, 2008William
                L. WallExecutive
                Vice President, Chief FinancialOfficer
                and Secretary(Principal
                Financial and Accounting Officer)/s/
                Linley H. Gibbs, Jr.
            
            March
                11, 2008Linley
                H. Gibbs, Jr.Director/s/
                Frederick N. Holscher
            
            March
                11, 2008Frederick
                N. HolscherDirector/s/
                Frederick H. Howdy
            
            March
                11, 2008Frederick
                H. HowdyDirector/s/
                Charles E. Parker, Jr.
            
            March
                11, 2008Charles
                E. Parker, Jr.Director/s/
                Marshall T. Singleton
            
            March
                11, 2008Marshall
                T. SingletonDirector/s/
                H. D. Reaves, Jr.
            
            March
                11, 2008H.
                D. Reaves, Jr.


Director