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, 2006

                                       OR

|_|   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. Employer
          incorporation 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 on
                                                          which 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 |_| 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 |_| 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 |_|

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, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act (Check
one):

Large accelerated filer |_|   Accelerated filer |X|   Non-accelerated filer |_|

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

The aggregate market value of voting stock held by nonaffiliates of the
registrant at June 30, 2006, was approximately $277.1 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 1, 2007: 9,943,842.

                       DOCUMENTS INCORPORATED BY REFERENCE

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

      1.    Portions of the Annual Report to Stockholders for the fiscal year
            ended December 31, 2006. (Part II)

      2.    Portions of Proxy Statement for the 2007 Annual Meeting of
            Stockholders. (Part II and Part III)

<PAGE>

                                     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

      Although 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, 2006, 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

<PAGE>

      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 Reserve for
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 the reserve for 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 the reserve for 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 the reserve for 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 reserve for
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 $826.4 million at December 31, 2006, representing
90.8% 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, 2006, commercial real estate
loans amounted to $586.2 million, or 70.9% of the Company's gross loan
portfolio. In recent years, the Company has sought to increase originations of
commercial business loans and consumer loans. At December 31, 2006, commercial
business loans totaled $42.6 million, or 5.2% of the Company's gross loan
portfolio, and consumer loans totaled $106.5 million, or 12.9% of the Company's
gross loan portfolio. To a lesser extent, the Company also originates
multi-family residential real estate loans. At December 31, 2006, $62.4 million,
or 7.5% of the Company's gross loan portfolio, consisted of single-family,
residential mortgage loans. The Company's residential mortgage construction
loans totaled $13.2 million, or 1.6% of the Company's gross loan portfolio, at
December 31, 2006.


                                        2

<PAGE>

      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, 2006, the Company had no concentrations of
loans exceeding 10% of gross loans other than as disclosed below.

<TABLE>
<CAPTION>
                                                                               At December 31,
                                           ---------------------------------------------------------------------------------------
                                                 2006              2005              2004              2003              2002
                                           ---------------   ---------------   ---------------   ---------------   ---------------
                                            Amount     %      Amount     %     Amount      %      Amount     %      Amount     %
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
                                                                            (Dollars in thousands)
<S>                                        <C>       <C>     <C>       <C>     <C>       <C>     <C>       <C>     <C>       <C>
Residential mortgage loans:
  Single-family residential.............   $ 62,352    7.5%  $ 49,363    6.2%  $ 53,149    7.6%  $ 64,549   10.8%  $103,852   19.6%
  Multi-family residential..............      2,897    0.4      2,885    0.4      2,956    0.4      3,650    0.6      6,360    1.2
  Construction..........................     13,211    1.6     25,304    3.1     22,687    3.3      9,921    1.7     17,070    3.2
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
    Total residential mortgage loans....     78,460    9.5     77,552    9.7     78,792   11.3     78,120   13.1    127,282   24.0
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
Commercial loans and leases:
  Commercial real estate................    586,178   70.9    570,469   71.4    470,809   67.4    372,430   62.3    274,564   51.8
  Commercial business...................     42,645    5.2     38,457    4.8     38,891    5.6     47,646    7.9     39,926    7.5
  Lease receivables.....................     12,640    1.5     11,981    1.5     11,622    1.6     10,422    1.7      6,624    1.3
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
    Total commercial loans and leases...    641,463   77.6    620,907   77.7    521,322   74.6    430,076   71.9    321,114   60.6
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
Consumer loans:
  Automobile............................      3,748    0.5      4,851    0.6      3,890    0.5      4,045    0.7      4,618    0.8
  Savings account loans.................      2,639    0.3      1,826    0.2      1,394    0.2      1,829    0.3      2,003    0.4
  Home equity loans.....................     42,153    5.1     42,084    5.3     42,330    6.1     38,533    6.5     35,471    6.7
  Other.................................     57,945    7.0     51,783    6.5     50,827    7.3     45,072    7.5     39,770    7.5
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
    Total consumer loans................    106,485   12.9    100,544   12.6     98,441   14.1     89,479   15.0     81,862   15.4
                                           --------  -----   --------  -----   --------  -----   --------  -----   --------  -----
      Total.............................    826,408  100.0%   799,003  100.0%   698,555  100.0%   598,097  100.0%   530,258  100.0%
                                           --------  =====   --------  =====   --------  =====   --------  =====   --------  =====
Less:
  Construction loans in process.........     54,390            80,528            57,194            36,280            31,450
  Deferred fees and discounts...........      1,423             1,433             1,202               983               935
  Allowance for loan and lease losses...      9,158             8,113             8,343             7,634             6,959
                                           --------          --------          --------          --------          --------
    Total...............................   $761,437          $708,929          $631,816          $553,200          $490,914
                                           ========          ========          ========          ========          ========
</TABLE>


                                        3

<PAGE>

      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.

<TABLE>
<CAPTION>
                                                                   At December 31,
                                                         -----------------------------------
                                                               2006               2005
                                                         ----------------   ----------------
                                                          Amount      %      Amount      %
                                                         --------   -----   --------   -----
                                                                (Dollars in thousands)
<S>                                                      <C>        <C>     <C>        <C>
Residential mortgage loans:
  Construction........................................    $ 3,770     2.6%  $  9,529     5.2%
                                                         --------   -----   --------   -----
    Total residential mortgage loans..................      3,770     2.6      9,529     5.2
                                                         --------   -----   --------   -----

Commercial loans and leases:
  Real estate secured.................................     12,244     8.3     29,067    15.7
  Non-Real Estate.....................................     20,060    13.6     15,388     8.3
  Standby Letters of Credit...........................      2,720     1.9      2,031     1.1
  Construction........................................     47,920    32.6     67,567    36.6
                                                         --------   -----   --------   -----
    Total commercial loans and leases.................     82,944    56.4    114,053    61.7
                                                         --------   -----   --------   -----

Consumer loans:
  Home equity loans...................................     48,590    33.0     47,864    25.9
  Real Estate Secured.................................        166     0.1        177     0.1
  Non-Real Estate.....................................      8,935     6.1      9,760     5.3
  Construction........................................      2,699     1.8      3,431     1.8
                                                         --------   -----   --------   -----
    Total consumer loans..............................     60,390    41.0     61,232    33.1
                                                         --------   -----   --------   -----
      Total Unfunded Commitments......................   $147,104   100.0%  $184,814   100.0%
                                                         --------   =====   --------   =====
</TABLE>

Loan Maturities. The following table sets forth certain information at December
31, 2006 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.

<TABLE>
<CAPTION>
                                                                          Due After 1 Through   Due After 5 of More
                                                             Due One         5 Years After          Years After
                                                           Year or Less    December 31, 2006     December 31, 2006      Total
                                                           ------------   -------------------   -------------------   --------
                                                                                     (In thousands)
<S>                                                          <C>                <C>                    <C>            <C>
Residential real estate loans...........................     $ 42,692           $ 47,878               $55,645        $146,215
Commercial real estate, business and other loans........      384,178            198,622                43,003         625,803
                                                             --------           --------               -------        --------
  Total.................................................     $426,870           $246,500               $98,648        $772,018
                                                             ========           ========               =======        ========
</TABLE>

      The following table sets forth at December 31, 2006 the dollar amount of
all loans due one year or more after December 31, 2006 which have predetermined
interest rates and have floating or adjustable interest rates.

                                      Predetermined      Floating or
                                          Rates       Adjustable Rates
                                      -------------   ----------------
                                               (In thousands)
Residential real estate loans......      $ 94,359          $9,164
Commercial real estate, business
  and other loans..................       241,137             488
                                         --------          ------
    Total..........................      $335,496          $9,652
                                         ========          ======


                                        4

<PAGE>

      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, 2006, 2005 and 2004, these
transactions totaled $18.4 million, $29.2 million and $40.5 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.

      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. All loans to a single borrower
aggregating in excess of $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 by 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 Department of Housing and Urban Development, pay
flood insurance policy premiums.


                                        5

<PAGE>

      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 $12.2 million at December 31, 2006. 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, 2006, single-family, residential
mortgage loans, excluding home improvement loans, totaled $62.4 million, or 7.5%
of the Company's gross loan portfolio.

      The Bank originates fixed-rate mortgage loans at competitive interest
rates. At December 31, 2006, $38.6 million, or 4.7%, 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
FHA and VA mortgage loans in its market area, which are underwritten, closed and
sold to a correspondent 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 or five 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 5.0% 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, 2006, $39.9 million, or 4.8%,
of the Company's residential mortgage loans were adjustable-rate loans.

      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.


                                        6

<PAGE>

      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 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, 2006,
$13.2 million, or 1.6%, of the Company's gross loan portfolio consisted of
construction loans, virtually all of which was secured by single-family
residences.

      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. 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 1%
construction loan fee and 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, 2006, multi-family residential and
commercial real estate loans totaled $2.9 million and $586.2 million,
respectively, which amounted to 0.4% and 70.9%, 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

<PAGE>

      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. In addition, in the case of commercial mortgage
loans made to a partnership or a corporation, the Bank obtains personal
guarantees and 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."

      In recent years, the Bank has emphasized commercial business lending. 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 $2,000,000. At December 31, 2006, commercial
business loans totaled $42.6 million, or 5.2% 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 loans over $20,000 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.

      Consumer Lending. In recent years, the Bank has been successful in its
strategy of increasing its portfolio of 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, 2006, consumer loans totaled $106.5 million, or 12.9% of
the Company's gross loan portfolio.


                                        8

<PAGE>

      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, 2006, loans on certificates of deposit totaled $2.6
million, or 0.3% of the Company's gross loan portfolio.

      At December 31, 2006, the Company had approximately $42.2 million in home
equity line of credit loans, representing approximately 5.1% 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 5% 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.

      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 are generally charged off, or any expected loss is reserved for, after
they become more than 120 days past due. 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 2006 Annual Report filed as Exhibit 13
hereto.


                                        9

<PAGE>

      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 losses. See Note 1 of Notes to Consolidated Financial Statements in the
2006 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.

<TABLE>
<CAPTION>
                                                                 At December 31,
                                                    ------------------------------------------
                                                     2006     2005     2004     2003     2002
                                                    ------   ------   ------   ------   ------
                                                              (Dollars in thousands)
<S>                                                 <C>      <C>      <C>      <C>      <C>
Loans accounted for on a nonaccrual basis:
Residential mortgage:
    Single-family................................   $  934   $1,362   $  814   $1,057   $  460
  Commercial real estate.........................    1,274      555    1,241    1,334      427
  Commercial business............................       79      220       49       19      219
  Consumer.......................................     453      122      245      215      247
                                                    ------   ------   ------   ------   ------
    Total nonperforming loans....................   $2,740   $2,259   $2,349   $2,625   $1,496
                                                    ======   ======   ======   ======   ======
Percentage of total loans, net...................     0.36%    0.32%    0.37%    0.47%    0.30%
                                                    ======   ======   ======   ======   ======
Real estate owned................................      634       14       89      131      402
                                                    ======   ======   ======   ======   ======
</TABLE>

      During the year ended December 31, 2006, additional gross interest income
of approximately $143,407 would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current throughout this period.

      At December 31, 2006, 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, 2006, 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, 2006, the Company had $2.7 million of nonaccrual loans,
which consisted of 13 single-family residential real estate loans totaling
$934,000, four commercial real estate loans totaling $1.3 million, four
commercial business loans totaling $79,000 and 14 consumer loans totaling
$453,000.

      At December 31, 2006, the Bank had $634,000 of real estate owned, which
consisted of one lot loan, one single family residence and one commercial
property.


                                       10

<PAGE>

      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,
2006, the Company had $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, compared to $19.2 million in classified assets,
including $11.0 million in assets classified as special mention, $8.2 million in
assets classified as substandard and no assets classified as doubtful or loss at
December 31, 2005.

      Allowance for Loan and Lease Losses and Reserve for Unfunded Loan
Commitments. The Bank maintains both general and specific allowances for loan
and lease losses and a reserve 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 reserve for 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 the reserve for
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 reserve for unfunded loan commitments. The factors supporting the
allowances for loan and lease losses and the reserve for unfunded loan
commitments do no diminish the fact that the entire allowances for loan and
lease losses and the reserve for unfunded loan commitments are available to
absorb losses in the loan and leases portfolio and the related loan commitment
portfolio, respectively. The Bank's principal focus is on the adequacy of the
total allowances for loan and losses and the reserve for 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 loan is
adequate. However, future additions to the allowance for losses may be necessary
based on changes in economic conditions and other factors.


                                       11

<PAGE>

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

                                                    Reserve for
                               Allowance for Loan     Unfunded    Allowance for
                                and Lease Losses    Commitments   Credit Losses
                               ------------------   -----------   -------------
                                             (Dollar in thousands)
Balance at December 31, 2001         $5,371            $   --         $5,371
Provision for credit losses           1,756                --          1,756
Loans and Leases charged-off           (193)               --           (193)
Loans and Leases recovered               25                --             25
                                     ------            ------         ------
Net (charge-offs)/recoveries           (168)               --           (168)
                                     ------            ------         ------
Balance at December 31, 2002          6,959                --          6,959
                                     ======            ======         ======

Balance at December 31, 2002          6,959                --          6,959
Provision for credit losses             988                --            988
Loans and Leases charged-off           (358)               --           (358)
Loans and Leases recovered               45                --             45
                                     ------            ------         ------
Net (charge-offs)/recoveries           (313)               --           (313)
                                     ------            ------         ------
Balance at December 31, 2003          7,634                --          7,634
                                     ======            ======         ======

Balance at December 31, 2003          7,634                --          7,634
Provision for credit losses             968                --            968
Loans and Leases charged-off           (302)               --           (302)
Loans and Leases recovered               43                --             43
                                     ------            ------         ------
Net (charge-offs)/recoveries           (259)               --           (259)
                                     ------            ------         ------
Balance at December 31, 2004          8,343                --          8,343
                                     ======            ======         ======

Balance at December 31, 2004          8,343                --          8,343
Provision for credit losses             602             1,109          1,711
Loans and Leases charged-off           (848)               --           (848)
Loans and Leases recovered               16                --             16
                                     ------            ------         ------
Net (charge-offs)/recoveries           (832)               --           (832)
                                     ------            ------         ------
Balance at December 31, 2005          8,113             1,109          9,222
                                     ======            ======         ======

Balance at December 31, 2005          8,113             1,109          9,222
Provisions for credit losses          1,277              (344)           933
Loans and Leases charged-off           (342)               --           (342)
Loans and Leases recovered              110                --            110
                                     ------            ------         ------
Net (charge-offs)/recoveries           (232)               --           (232)
                                     ------            ------         ------
Balance at December 31, 2006         $9,158            $  765         $9,923
                                     ======            ======         ======


                                       12

<PAGE>

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

<TABLE>
<CAPTION>
                                                                           At December 31,
                                 --------------------------------------------------------------------------------------------------
                                        2006                2005                2004                2003                2002
                                 ------------------  ------------------  ------------------  ------------------  ------------------
                                         Percent of          Percent of          Percent of          Percent of          Percent of
                                          Loans in            Loans in            Loans in            Loans in            Loans in
                                          Category            Category            Category            Category            Category
                                          to Total            to Total            to Total            to Total            to Total
                                 Amount     Loans    Amount     Loans    Amount     Loans    Amount     Loans    Amount    Loans
                                 ------  ----------  ------  ----------  ------  ----------  ------  ----------  ------  ----------
                                                                       (Dollars in thousands)
<S>                              <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Allowance for Loan and
  Lease Losses:
    Residential mortgage.......  $  510      9.5%    $  510      9.7     $1,034     11.3%    $1,034     13.1%    $1,034     24.0%
    Commercial (1)(2)..........   7,309     77.6      6,279     77.7      6,362     74.6      5,487     71.9      4,726     60.6
    Consumer (3)...............   1,339     12.9      1,324     12.6        947     14.1      1,113     15.0      1,199     15.4
                                 ------    -----     ------    -----     ------    -----     ------    -----     ------    -----
Total allowance for loan
  losses.......................  $9,158    100.0%    $8,113    100.0%    $8,343    100.0%    $7,634    100.0%    $6,959    100.0%
                                 ======    =====     ======    =====     ======    =====     ======    =====     ======    =====

Reserve for Unfunded
  Commitments:
    Mortgage...................  $   20      2.6%    $   57      5.1%
    Commercial.................     431     56.4        684     61.7
    Consumer...................     314     41.0        368     33.2
                                 ------    -----     ------    -----
Total reserve for unfunded
  commitments..................  $  765    100.0%    $1,109    100.0%
                                 ======    =====     ======    =====
Combined total allowance for
  credit losses................  $9,923              $9,222
                                 ======              ======
</TABLE>

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

(2)   Includes $407,197 of specific allowance for loan losses on three
      commercial business loans.

(3)   Includes $15,346 of specific allowance for loan losses on one consumer
      loan.


                                       13

<PAGE>

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, 2006, the Company's mortgage-backed securities and investment
securities portfolio amounted to $36.7 million and $56.5 million, respectively.
At such date, the Company had an unrealized loss of $579,000, 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, 2006, the Company's
mortgage-backed securities amounted to $36.7 million, or 4.0% 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, 2006, 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, 2006, mortgage-backed securities with an amortized cost of
$35.5 million and a carrying value of $35.1 million were held as available for
sale, and mortgage-backed securities with an amortized cost of $1.7 million and
a carrying value of $1.7 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, 2006, the Bank's
mortgage-backed securities had a weighted average yield of 5.48%. See Notes 1, 2
and 3 of the Notes to Consolidated Financial Statements in the 2006 Annual
Report filed as Exhibit 13 hereto.


                                       14

<PAGE>

      At December 31, 2006, the average contractual maturity of the Company's
fixed-rate mortgage-backed securities available-for-sale was approximately 25.4
years, while the average contractual maturity of mortgage-backed securities held
for investment was approximately 6.7 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, 2006, the Company's entire portfolio of investment securities
was classified available for sale and amounted to $56.5 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,
2006, the estimated average life of the Company's investment securities
portfolio was approximately 2.4 years. In addition, at December 31, 2006, the
Company had $1.9 million of FHLB stock.

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

                                                           At December 31,
                                                     ---------------------------
                                                       2006      2005      2004
                                                     -------   -------   -------
                                                            (In thousands)
Securities available for sale:
  U.S. government and agency securities...........   $56,454   $41,827   $32,058
  Mortgage-backed securities......................    35,067    20,639     6,639
                                                     -------   -------   -------
    Total.........................................   $91,521   $62,466   $38,697
                                                     =======   =======   =======

Securities held to maturity:
  FHLB stock......................................   $ 1,933   $ 1,689   $ 1,825
  Mortgage-backed securities......................     1,663     2,063     2,569
                                                     -------   -------   ------
    Total.........................................   $ 3,596   $ 3,752   $ 4,394
                                                     =======   =======   =======


                                       15

<PAGE>

      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, 2006.

<TABLE>
<CAPTION>
                       One Year of Less   One to Five Years  Five to Ten Years  More than Ten Years   Total Investment Portfolio
                       -----------------  -----------------  -----------------  -------------------  ----------------------------
                       Carrying  Average  Carrying  Average  Carrying  Average  Carrying    Average  Carrying  Amortized  Average
                        Value     Yield    Value     Yield     Value    Yield    Value       Yield     Value      Cost     Yield
                       --------  -------  --------  -------  --------  -------  --------   --------  --------  ---------  -------
                                                                (Dollars in thousands)
<S>                     <C>       <C>      <C>       <C>      <C>        <C>     <C>         <C>      <C>       <C>        <C>
Securities available
  for sale:
U.S. government
  and agency
  securities.........   $8,992    5.49%    $47,462   4.54%    $   --       --%   $    --       --%    $56,454   $56,931    4.69%
Mortgage-backed
  securities.........       11    7.50         211   6.21      3,334     6.25     31,511     5.39      35,067    35,532    5.48
Securities held to
  maturity:
FHLB stock (1).......       --      --          --     --         --       --      1,933     5.90       1,933     1,933    5.90
Mortgaged-backed
  securities.........       --      --          --     --      1,663     4.00         --       --       1,663     1,663    4.00
                        ------    ----     -------   ----     ------     ----    -------     ----     -------   -------    ----
Total................   $9,003    5.49%    $47,673   4.55%    $4,997     5.50%   $33,444     5.42%    $95,117   $96,059    4.99%
                        ======    ====     =======   ====     ======     ====    =======     ====     =======   =======    ====
</TABLE>

----------
(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

<PAGE>

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-four
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.

<TABLE>
<CAPTION>
                                                      At December 31,
                              ---------------------------------------------------------------
                                     2006                   2005                  2004
                              -------------------   -------------------   -------------------
                                         Weighted              Weighted              Weighted
                                          Average               Average               Average
                               Amount      Rate      Amount      Rate      Amount      Rate
                              --------   --------   --------   --------   --------   --------
                                                   (Dollars in thousands)
<S>                           <C>          <C>      <C>          <C>      <C>          <C>
Demand accounts:
  Checking.................   $239,251     1.03%    $223,358     0.45%    $215,349     0.45%
  Money market.............     25,471     2.65       21,521     1.35       20,971     0.72
Savings accounts...........     18,481     0.15       21,510     0.15       22,018     0.15
                              --------     ----     --------     ----     --------     ----
  Total....................   $283,203     1.12%    $266,389     0.50%    $258,338     0.45%
                              ========              ========              ========

Certificate accounts:
  Less than 12 months (1)..   $264,386     4.97%    $ 64,456     3.21%    $ 86,133     1.77%
  12-14 months (1).........    170,786     4.82      203,127     3.87       98,958     2.15
  15-72 months (1).........     81,813     4.11      199,781     3.47      185,107     2.89
                              --------     ----     --------     ----     --------     ----
  Total....................    516,985     4.78      467,364     3.61      370,198     2.43
                              --------     ----     --------     ----     --------     ----
Total deposits.............   $800,188     3.48%    $733,753     2.48%    $628,536     1.62%
                              ========              ========              ========
</TABLE>

----------
(1)   Original term.

      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,
2006. At such date, such deposits represented 22.6% of total deposits and had a
weighted average rate of 4.95%.


                                       17

<PAGE>

                       Maturity Period           (In thousands)
              --------------------------------
              Three months or less............      $    991
              Over three months...............         2,811
              Over six through 12 months......       104,806
              Over 12 months..................        72,471
                                                    --------
                Total.........................      $181,079
                                                    ========

      At December 31, 2006, U.S. Agency Bonds with an amortized cost of $13.4
million were pledged as collateral for deposits from public entities and
repurchase agreements.

      Borrowings. Savings 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, 2006, 2005 and
2004, 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:

<TABLE>
<CAPTION>
                                                          At or for the Year Ended December 31,
                                                          -------------------------------------
                                                              2006         2005         2004
                                                          -----------   ----------   ----------
                                                                      (In thousands)
<S>                                                         <C>          <C>          <C>
Amounts outstanding at end of periods:
  FHLB advances........................................     $ 6,000      $ 5,500      $10,500
  Federal funds purchased and securities sold under
    repurchase agreements..............................       5,140        6,288        4,292
Rate paid on:
  FHLB advances........................................        5.50%        4.44%        2.44%

  Federal funds purchased and securities sold under
    agreement to repurchase............................        4.86%        3.59%        1.62%
Maximum amount of borrowings outstanding at any month
  end:
  FHLB advances........................................      31,600       24,500       46,500
  Federal funds purchased and securities sold under
    repurchase agreements..............................       8,556        7,012        4,960
Approximate average short-term borrowings outstanding
  with respect to:
  FHLB advances........................................      11,969        4,068       19,108
  Federal funds purchased and securities sold under
    repurchase agreements..............................       6,625        6,182        4,019
Approximate weighted average rate paid on: (1)
  FHLB advances........................................        5.27%        2.97%        1.46%
  Federal funds purchased and securities sold under
    repurchase agreements..............................        4.41%        2.71%        0.92%
</TABLE>

----------
(1)   Based on month-end balances.


                                       18

<PAGE>

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, 2006, the Bank had 259 full-time and 35 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

<PAGE>

      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

<PAGE>

      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.

<TABLE>
<CAPTION>
                                        Adequately                         Significantly
                    Well Capitalized    Capitalized   Undercapitalized   Undercapitalized
                    ----------------   ------------   ----------------   ----------------
<S>                 <C>                <C>            <C>                <C>
Total risk-based
  capital ratio     10.0% or more      8.0% or more   Less than 8.0%     Less than 6.0%
Tier 1 risk-based
  capital 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%
</TABLE>

----------
*     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.

      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."


                                       21

<PAGE>

      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, 2006, of $1.9 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
$8.58 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,
2006, 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 is expected to be $406,540. 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.

      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 ending December 31, 2006
averaged 1.28 basis points of assessable deposits.


                                       22

<PAGE>

      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 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 16.0% of total deposits at
December 31, 2006, 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 $13.7 million at
December 31, 2006. 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, 2006, the Bank's largest lending relationship was a $9.6 million
relationship consisting of two commercial real estate loans, two letters of
credit and one consumer line of credit. All loans within this relationship were
current and performing in accordance with their terms at December 31, 2006.

      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

<PAGE>

      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.

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.


                                       24

<PAGE>

      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.

      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.


                                       25

<PAGE>

      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.

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.


                                       26

<PAGE>

      For additional information regarding taxation, see Notes 1 and 10 of Notes
to Consolidated Financial Statements in the 2006 Annual Report filed as Exhibit
13 hereto.

Item 1A. Risk Factors

      Certain interest rate movements may impact earnings and asset value.

      Prior to 2006, interest rates have recently been at historically low
levels. However, since December 31, 2005, the prime lending rate has increased
from 7.25% to 8.25% at December 31, 2006. Short-term and intermediate-term
market interest rates are used as a guide to price the Bank's loans and
deposits. The recent increase in such interest rates has had a positive impact
on the Bank's interest rate spread and net interest margin to date, as a result
of the asset sensitive nature of the Bank's balance sheet. 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 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.

      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, 2006, the Company had commercial real
estate, commercial business and consumer loans totaling $586.2 million, $42.6
million and $106.5 million, respectively, which represented 70.9%, 5.2% and
12.9%, respectively, of total loans. As December 31, 2006, $78.5 million, or
9.5% of total loans, consisted of residential real estate mortgage loans.


                                       27

<PAGE>

      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, 2006, 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.

      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.


                                       28

<PAGE>

      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, 2006.

<TABLE>
<CAPTION>
                                                                       Book Value   Approximate
                                                                      at December      Square
                                      Year Opened   Owned or Leased     31, 2006      Footage
                                      -----------   ---------------   -----------   -----------
                                                        (Dollars in thousands)
<S>                                       <C>            <C>             <C>           <C>
Main Office:
1311 Carolina Avenue
Washington, NC                            1986            Owned          $1,151        10,200

Branch Offices:
300 North Market Street
Washington, NC                            1959            Owned             125         4,680

1328 John Small Avenue
Washington, NC                            2001           Leased               7         1,916

2999 Hwy. 17S.
Chocowinity, NC                           1999             **               278         2,530

301 E. Arlington Boulevard
Greenville, NC                            1993            Owned             297         2,600

907 E. Firetower Road
Greenville, NC                            2005            Owned             795         2,245

604 E. Ehringhaus Street
Elizabeth City, NC                        1980            Owned             134         2,500
</TABLE>


                                       29

<PAGE>

<TABLE>
<CAPTION>
                                                                       Book Value   Approximate
                                                                      at December      Square
                                      Year Opened   Owned or Leased     31, 2006      Footage
                                      -----------   ---------------   -----------   -----------
                                                        (Dollars in thousands)
<S>                                       <C>            <C>             <C>           <C>
1906 S. Croatan Street
Kill Devil Hills, NC                      2002           Leased              64         2,000

2600 N. Croatan Street
Kill Devil Hills, NC                      2004           Leased               6           688

47560 Hwy. 12
Avon, NC 27915                            2005           Leased             554           120

2430 Heritage Street
Kinston, NC                               2001           Leased              34         2,145

1725 Glenburnie Road
New Bern, NC                              1990            Owned             275         2,600

202 Craven Street
New Bern, NC                              1995           Leased              --         2,500

2019 S. Glenburnie Road
Crossroads Shopping Center
New Bern, NC                              2004           Leased              61           435

241 Green Street
Fayetteville, NC                          1999            Owned             735        10,000

3107 Raeford Road
Fayetteville, NC                          1999            Owned             372         2,400

600 N. Chestnut Street
Lumberton, NC                             1999            Owned             317         6,100

3000 N. Elm Street
Lumberton, NC                             2001           Leased              39         2,128

3103 N. Main Street
Hope Mills, NC                            2004            Owned             533         2,200

100 East Hope Lodge Street
Tarboro, NC                               2000           Leased              11         1,350

300 Sunset Avenue
Rocky Mount, NC                           1994            Owned             286         4,948

2901 Sunset Avenue
Rocky Mount, NC                           2000            Owned           1,023         5,635

450 North Winstead Avenue
Rocky Mount, NC                           2000           Leased              27         2,845

1378 Benvenue Road
Rock Mount, NC                            2000             **               311         5,376

3635 North Halifax Road
Dortches, NC                              2000           Leased              32           396
</TABLE>


                                       30

<PAGE>

<TABLE>
<CAPTION>
                                                                       Book Value   Approximate
                                                                      at December      Square
                                      Year Opened   Owned or Leased     31, 2006      Footage
                                      -----------   ---------------   -----------   -----------
                                                        (Dollars in thousands)
<S>                                       <C>            <C>             <C>           <C>
4800 Six Forks Road
Six Forks III, Suite #115
Raleigh, NC                               2004           Leased              96         4,501

1802 Martin Luther King Jr. Parkway
Suite 108
Durham, NC                                2004           Leased               4           950

Credit Administration:
Creekside 2
220 Creekside Drive
Washington, NC                            1994            Owned             705         7,600

Operations Center:
Creekside 1
220 Creekside Drive
Washington, NC                            2001            Owned             561        10,000

First South Leasing, LLC:
1035 Director Court
Suite C
Greenville, NC                            2001           Leased              32         1,146
</TABLE>

----------
**    Lease land, own building.

      The book value of the Bank's investment in premises and equipment was $8.9
million at December 31, 2006. See Notes 1 and 5 to Consolidated Financial
Statements in the 2006 Annual Report filed as Exhibit 13 hereto.

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, 2006, 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," "-- Stock Price Information" and
"Comparative Stock Performance Graph" in the Company's Annual Report to
Stockholders for the Fiscal Year Ended December 31, 2006 (the "Annual Report")
filed as Exhibit 13 hereto is incorporated herein by reference.

      (b) Not applicable.


                                       31

<PAGE>

      (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.

<TABLE>
<CAPTION>
                                  (a)           (b)               (c)                   (d)
                                                                 Total                Maximum
                                 Total                     Number of Shares       Number of Shares
                               Number of      Average    Purchased as Part of     that May Yet Be
                                Shares      Price Paid    Publicly Announced    Purchased Under the
          Period             Purchased(1)    per Share      Plans Programs       Plans or Programs
--------------------------   ------------   ----------   --------------------   -------------------
<S>                              <C>          <C>               <C>                   <C>
October 2006
Beginning date: October 1
Ending date: October 31          7,782        $33.25            7,782                 294,604

November 2006
Beginning date: November 1
Ending date: November 30            50         31.03               50                 294,554

December  2006
Beginning date: December 1
Ending date: December 31            13         30.98               13                 294,541
                                 -----        ------            -----                 -------
Total                            7,845        $33.23            7,845                 294,541
                                 =====        ======            =====                 =======
</TABLE>

----------

(1) The shares were repurchased pursuant to a repurchase program announced on
January 11, 2006. Under this program, the Company announced that it would
repurchase up to 319,022 shares of its Common Stock, as adjusted for a
subsequent three-for-two stock split. This program expired on January 8, 2007.
The Company purchased 24,481 shares of the 319,022 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 3 in the Annual Report is
incorporated herein by reference.

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" on
pages 4 through 14 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 "Market Risk" on page 6
in the Annual Report is incorporated herein by reference as Exhibit 13.

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
on pages 15 through 40 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 years ended December 31, 2005 and 2004 follows.


                                       32

<PAGE>

             Report of Independent Registered Public Accounting Firm

                        [Letterhead of Dixon Hughes PLLC]

To the Stockholders and the Board of Directors First South Bancorp, Inc.
Washington, North Carolina

We have audited the accompanying consolidated statement of financial condition
of First South Bancorp, Inc. and Subsidiary as of December 31, 2005, and the
related consolidated statements of operations, changes in stockholders' equity
and cash flows for each of the years in the two-year period 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 audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of First South Bancorp,
Inc. and Subsidiary at December 31, 2005 and the results of their operations and
their cash flows for each of the years in the two-year period 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.


/s/ 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


                                       33

<PAGE>

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 2007 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. (the "Company") is responsible for
the preparation, integrity, and fair presentation of its published financial
statements as of December 31, 2006, 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, 2006.

      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.

      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, 2006.


                                       34

<PAGE>

      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, 2006, 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, 2006, which is included herein.

First South Bancorp, Inc.
March 7, 2007


/s/ Thomas A. Vann                      /s/ William L. Wall
-------------------------------------   ----------------------------------------
Thomas A. Vann                          William L. Wall
President and Chief Executive Officer   Executive Vice President and
                                        Chief Financial Officer

Attestation Report of Independent Registered Public Accounting Firm

                   [Letterhead of Turlington and Company, LLP]

To the Board of Directors and Stockholders
First South Bancorp, Inc.
Washington, North Carolina

We have audited management's assessment, included in the accompanying
Management's Annual Report on Internal Control Over Financial Reporting, that
First South Bancorp, Inc. (the "Company") maintained effective internal control
over financial reporting as of December 31, 2006, based on criteria established
in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring
Organizations of the Treadway Commission. The Company'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 and for its assessment of the effectiveness of internal control over
financial reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of 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 included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and 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.


                                       35

<PAGE>

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, management's assessment that First South Bancorp, Inc.
maintained effective internal control over financial reporting as of December
31, 2006, is fairly stated, in all material respects, based on criteria
established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the
Company maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2006, based on criteria established in
INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring
Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated statement of
financial condition of the Company as of December 31, 2006 and the related
consolidated statements of operations, changes in stockholders' equity and cash
flows for the year then ended December 31, 2006, and our report dated March 6,
2007, expressed an unqualified opinion on those consolidated financial
statements.

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, LLP

Lexington, North Carolina
March 6, 2007

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.


                                       36

<PAGE>

Item 11. Executive Compensation

      The information contained under the sections captioned "Proposal I --
Election of Directors," "-- Compensation Committee Report" "-- Executive
Compensation" and "-- Director Compensation" in the Proxy Statement is
incorporated herein by reference.

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, 2006.

<TABLE>
<CAPTION>
                                             (a)                           (c)                             (b)
                                                                                             Number of securities remaining
                                 Number of securities to be                                  available for future issuance
                                   issued upon exercise of      Weighted-average exercise       under equity compensation
                                    outstanding options,          price of outstanding         plans (excluding securities
                                    warrants and rights       options, warrants and rights      reflected in column (a))
                                 --------------------------   ----------------------------   ------------------------------
<S>                                       <C>                            <C>                             <C>
Equity compensation plans                 583,374                        $9.65                           988,277
  approved by security holders
Equity compensation plans not
  approved by security holders                 --                           --                                --
                                          -------                        -----                           -------
Total                                     583,374                        $9.65                           988,277
                                          =======                        =====                           =======
</TABLE>

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 Accountant" in
the Proxy Statement.

                                     PART IV

Item 15. Exhibits and Financial Statement Schedules

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


                                       37

<PAGE>

      (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, 2006 and
      2005

      Consolidated Statements of Operations for the Years Ended December 31,
      2006, 2005 and 2004

      Consolidated Statements of Changes in Stockholders Equity for the Years
      Ended December 31, 2006 and 2005 and 2004

      Consolidated Statements of Cash Flows for the Years Ended December 31,
      2006 and 2005 and 2004

      Notes to Consolidated Financial Statements

      (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(a)   Employment Agreement between First South Bancorp, Inc. and Thomas A.
          Vann, as amended (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(b)   Employment Agreement between First South Bank and Thomas A. Vann, as
          amended (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))*

10.2      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 James F. Buckman, 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      Home Savings Bank, SSB 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      First South Bank 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
          2004 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))*


                                       38

<PAGE>

10.7      Home Savings Bank, SSB 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))*

10.8      Home Savings Bank, SSB Directors Retirement Plan Agreement with
          Marshall Singleton and the 2004 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 omitted

10.11     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

10.12     Change-in-Control Protective Agreement between First South Bank, First
          South Bancorp, Inc. and William L. Wall dated January 1, 2001
          (Incorporated herein by reference from Exhibit 10.12 to the Company's
          Annual Report on Form 10-K for the Year Ended September 30, 2001 (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,
          2006

21        Subsidiaries of the Registrant

23.1      Consent of Turlington and Company, LLP

23.2      Consent of Dixon Hughes PLLC

31.1      Rule 13a-14(a) Certification of Chief Executive Officer

31.2      Rule 13a-14(a) Certification of Chief Financial Officer

32        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.


                                       39

<PAGE>

                                   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 12, 2007

                                        By: /s/ Thomas A. Vann
                                            ------------------------------------
                                            Thomas A. Vann
                                            President

      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 12, 2007
-------------------------------------
Thomas A. Vann
President and Director
(Principal Executive Officer)


/s/ William L. Wall
-------------------------------------   March 12, 2007
William L. Wall
Executive Vice President,
Chief Financial Officer and Secretary
(Principal Financial and
Accounting Officer)


/s/ Linley H. Gibbs, Jr.                March 12, 2007
-------------------------------------
Linley H. Gibbs, Jr.
Director


/s/ Frederick N. Holscher               March 12, 2007
-------------------------------------
Frederick N. Holscher
Director


/s/ Frederick H. Howdy                  March 12, 2007
-------------------------------------
Frederick H. Howdy
Director


/s/ Charles E. Parker, Jr.              March 12, 2007
-------------------------------------
Charles E. Parker, Jr.
Director


/s/ Marshall T. Singleton               March 12, 2007
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Marshall T. Singleton
Director


/s/ H. D. Reaves, Jr.                   March 12, 2007
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H. D. Reaves, Jr.
Director