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, 2008


OR


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


For the
transition period from _________ to _________





Commission
File No.  0-22219





FIRST SOUTH BANCORP,
INC.


(Exact
name of registrant as specified in its charter)





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





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





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





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





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





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes  ̈  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 for 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, a non-accelerated filer or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act  (Check one):





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





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 common stock held by nonaffiliates of the registrant
at June 30, 2008, was approximately $103.8 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 10, 2009: 9,738,096.





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, 2008. (Part II)


2.
              Portions
      of Proxy Statement for the 2009 Annual Meeting of
      Stockholders.  (Part II and Part
III)





PART
I





Item
1.Business





Forward-Looking
Statements





The
Private Securities Litigation Reform Act of 1995 states that the disclosure of
forward looking information is desirable for investors and encourages such
disclosure by providing a safe harbor for forward looking statements by
corporate management.  This Annual Report on Form 10-K contains
forward looking statements that involve risk and uncertainty.  In
order to comply with the terms of the safe harbor, the Company notes that a
variety of risks and uncertainties could cause its actual results and experience
to differ materially from the anticipated results or other expectations
expressed in the Company's forward looking statements.  There are
risks and uncertainties that may affect the operations, performance,
development, growth projections and results of the Company's
business.  They include, but are not limited to, economic growth,
interest rate movements, timely development of technology enhancements for
products, services and operating systems, the impact of competitive products,
services and pricing, customer requirements, regulatory changes and similar
matters.  Readers of this report are cautioned not to place undue
reliance on forward looking statements that are subject to influence by these
risk factors and unanticipated events.  Accordingly, actual results
may differ materially from management's expectations.





General





First South Bancorp,
Inc.  First South Bancorp, Inc. (the “Company”) is a Virginia
corporation, incorporated on January 7, 1999, 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 Select Market under the symbol “FSBK”.





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





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





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





Market
Area





The
Company makes loans and obtains deposits throughout eastern, northeastern,
southeastern and central North Carolina, where the Bank’s offices are
located.  As of December 31, 2008, 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 comparable 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 throughoutNotes to Consolidated
Financial Statements and Management’s Discussion and Analysis of Financial
Condition and Results of Operation in the 2008 Annual Report filed as Exhibit 13
hereto, where such policies affect reported and expected financial
results.


1





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





Loan Impairment, Allowance for Loan
and Lease Losses and Unfunded Loan Commitments.A loan or
lease is considered impaired, based on current information and events, if it is
probable that the Bank will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan or
lease agreement.  Uncollateralized loans are measured for impairment
based on the present value of expected future cash flows discounted at the
historical effective interest rate, while all collateral-dependent loans are
measured for impairment based on the fair value of the collateral.





The Bank
uses several factors in determining if a loan or lease is
impaired.  The internal asset classification procedures include a
thorough review of significant loans, leases and lending relationships and
include the accumulation of related data.  This data includes loan and
lease payment status, borrowers’ financial data and borrowers’ operating factors
such as cash flows, operating income or loss, etc.





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





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





Off-Balance Sheet Risk.The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers and to
reduce its own exposure to fluctuations in interest rates.  These
financial instruments include commitments to extend credit and involve, to
varying degrees, elements of credit and interest rate risk in excess of the
amount recognized in the balance sheet.





The
Company’s exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit is
represented by the contractual amount of those instruments.  The
Company uses the same credit policies in making commitments and conditional
obligations as it does for on-balance sheet instruments.





Lending
Activities





General.  The
Company’s gross loan portfolio, including real estate construction loans in
process, totaled $791.5 million at December 31, 2008, representing 90.4% 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,
2008, commercial real estate and construction loans amounted to $587.2 million,
or 74.2% of the Company’s gross loan portfolio.  The Company has no
direct sub-prime or Alt-A loan exposure in its loan portfolio.  In
recent years, the Company has sought to increase originations of commercial
business loans and consumer loans.   At December 31, 2008,
commercial business loans totaled $40.5 million, or 5.1% of the Company’s gross
loan portfolio, and consumer loans totaled $103.7 million, or 13.1% of the
Company’s gross loan portfolio.  To a lesser extent, the Company also
originates multi-family residential real estate loans.  At December
31, 2008, $42.3 million, or 5.3% of the Company’s gross loan portfolio,
consisted of single-family, residential mortgage loans.  The Company’s
residential mortgage construction loans totaled $4.7 million, or 0.6% of the
Company’s gross loan portfolio, at December 31, 2008.


2


Loan Portfolio
Composition.  The following table sets forth selected data
relating to the composition of the Company’s loan portfolio by type of loan
at the
dates indicated.  At December 31, 2008, the Company had no
concentrations of loans exceeding 10% of gross loans other than as disclosed
below.





At December 31,2008
                            
                            
                            2007
                            
                            
                            2006
                            
                            
                            2005
                            
                            
                            2004Amount
                            
                            
                            %
                            
                            
                            Amount
                            
                            
                            %
                            
                            
                            Amount
                            
                            
                            %
                            
                            
                            Amount
                            
                            
                            %
                            
                            
                            Amount
                            
                            
                            %(Dollars
      in thousands)Residential
      mortgage loans:Single-family
      residential
                            
                            $
                            42,296
                            
                            
                            
                            5.3
                            %
                            
                            $
                            41,223
                            
                            
                            
                            4.9
                            %
                            
                            $
                            62,352
                            
                            
                            
                            7.5
                            %
                            
                            $
                            49,363
                            
                            
                            
                            6.2
                            %
                            
                            $
                            53,149
                            
                            
                            
                            7.6
                            %Multi-family
      residential
                            
                            
                            1,608
                            
                            
                            
                            0.2
                            
                            
                            
                            2,255
                            
                            
                            
                            0.3
                            
                            
                            
                            2,897
                            
                            
                            
                            0.4
                            
                            
                            
                            2,885
                            
                            
                            
                            0.4
                            
                            
                            
                            2,956
                            
                            
                            
                            0.4Construction
                            
                            
                            4,653
                            
                            
                            
                            0.6
                            
                            
                            
                            12,508
                            
                            
                            
                            1.5
                            
                            
                            
                            13,211
                            
                            
                            
                            1.6
                            
                            
                            
                            25,304
                            
                            
                            
                            3.1
                            
                            
                            
                            22,687
                            
                            
                            
                            3.3Total residential
      mortgage  loans
                            
                            
                            48,557
                            
                            
                            
                            6.1
                            
                            
                            
                            55,986
                            
                            
                            
                            6.7
                            
                            
                            
                            78,460
                            
                            
                            
                            9.5
                            
                            
                            
                            77,552
                            
                            
                            
                            9.7
                            
                            
                            
                            78,792
                            
                            
                            
                            11.3Commercial
      loans and leases:Commercial real
      estate
                            
                            
                            414,707
                            
                            
                            
                            52.4
                            
                            
                            
                            436,135
                            
                            
                            
                            52.3
                            
                            
                            
                            391,315
                            
                            
                            
                            47.3
                            
                            
                            
                            377,407
                            
                            
                            
                            47.2
                            
                            
                            
                            317,013
                            
                            
                            
                            45.4Commercial
      construction (1)
                            
                            
                            172,449
                            
                            
                            
                            21.8
                            
                            
                            
                            174,576
                            
                            
                            
                            21.0
                            
                            
                            
                            194,863
                            
                            
                            
                            23.6
                            
                            
                            
                            193,062
                            
                            
                            
                            24.2
                            
                            
                            
                            153,796
                            
                            
                            
                            22.0Commercial
      business
                            
                            
                            40,496
                            
                            
                            
                            5.1
                            
                            
                            
                            48,986
                            
                            
                            
                            5.9
                            
                            
                            
                            42,645
                            
                            
                            
                            5.2
                            
                            
                            
                            38,457
                            
                            
                            
                            4.8
                            
                            
                            
                            38,891
                            
                            
                            
                            5.6Lease
      receivables
                            
                            
                            11,561
                            
                            
                            
                            1.5
                            
                            
                            
                            13,101
                            
                            
                            
                            1.6
                            
                            
                            
                            12,640
                            
                            
                            
                            1.5
                            
                            
                            
                            11,981
                            
                            
                            
                            1.5
                            
                            
                            
                            11,622
                            
                            
                            
                            1.6Total commercial
      loans and leases
                            
                            
                            639,213
                            
                            
                            
                            80.8
                            
                            
                            
                            672,798
                            
                            
                            
                            80.8
                            
                            
                            
                            641,463
                            
                            
                            
                            77.6
                            
                            
                            
                            620,907
                            
                            
                            
                            77.7
                            
                            
                            
                            521,322
                            
                            
                            
                            74.6Consumer
      loans:Automobile
                            
                            
                            2,831
                            
                            
                            
                            0.4
                            
                            
                            
                            3,518
                            
                            
                            
                            0.4
                            
                            
                            
                            3,748
                            
                            
                            
                            0.5
                            
                            
                            
                            4,851
                            
                            
                            
                            0.6
                            
                            
                            
                            3,890
                            
                            
                            
                            0.5Savings account
      loans
                            
                            
                            1,427
                            
                            
                            
                            0.2
                            
                            
                            
                            1,793
                            
                            
                            
                            0.2
                            
                            
                            
                            2,639
                            
                            
                            
                            0.3
                            
                            
                            
                            1,826
                            
                            
                            
                            0.2
                            
                            
                            
                            1,394
                            
                            
                            
                            0.2Home equity
      loans
                            
                            
                            43,158
                            
                            
                            
                            5.4
                            
                            
                            
                            43,558
                            
                            
                            
                            5.2
                            
                            
                            
                            42,153
                            
                            
                            
                            5.1
                            
                            
                            
                            42,084
                            
                            
                            
                            5.3
                            
                            
                            
                            42,330
                            
                            
                            
                            6.1Other
                            
                            
                            56,318
                            
                            
                            
                            7.1
                            
                            
                            
                            55,544
                            
                            
                            
                            6.7
                            
                            
                            
                            57,945
                            
                            
                            
                            7.0
                            
                            
                            
                            51,783
                            
                            
                            
                            6.5
                            
                            
                            
                            50,827
                            
                            
                            
                            7.3Total consumer
      loans
                            
                            
                            103,734
                            
                            
                            
                            13.1
                            
                            
                            
                            104,413
                            
                            
                            
                            12.5
                            
                            
                            
                            106,485
                            
                            
                            
                            12.9
                            
                            
                            
                            100,544
                            
                            
                            
                            12.6
                            
                            
                            
                            98,441
                            
                            
                            
                            14.1Total
                            
                            
                            791,504
                            
                            
                            
                            100.0
                            %
                            
                            
                            833,197
                            
                            
                            
                            100.0
                            %
                            
                            
                            826,408
                            
                            
                            
                            100.0
                            %
                            
                            
                            799,003
                            
                            
                            
                            100.0
                            %
                            
                            
                            698,555
                            
                            
                            
                            100.0
                            %Less:Construction loans in
      process
                            
                            
                            34,133
                            
                            
                            
                            
                            
                            
                            
                            57,242
                            
                            
                            
                            
                            
                            
                            
                            54,390
                            
                            
                            
                            
                            
                            
                            
                            80,528
                            
                            
                            
                            
                            
                            
                            
                            57,194Deferred fees and
      discounts
                            
                            
                            1,022
                            
                            
                            
                            
                            
                            
                            
                            1,386
                            
                            
                            
                            
                            
                            
                            
                            1,423
                            
                            
                            
                            
                            
                            
                            
                            1,433
                            
                            
                            
                            
                            
                            
                            
                            1,202Allowance for loan
      and leaselosses
                            
                            
                            11,618
                            
                            
                            
                            
                            
                            
                            
                            9,486
                            
                            
                            
                            
                            
                            
                            
                            9,158
                            
                            
                            
                            
                            
                            
                            
                            8,113
                            
                            
                            
                            
                            
                            
                            
                            8,343Total
                            
                            $
                            744,731
                            
                            
                            
                            
                            
                            
                            $
                            765,083
                            
                            
                            
                            
                            
                            
                            $
                            761,437
                            
                            
                            
                            
                            
                            
                            $
                            708,929
                            
                            
                            
                            
                            
                            
                            $
                            631,816





(1)
Includes multifamily, 1-4 family and speculative single family residential and
commercial real estate construction loans.


3


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





At December 31,2008
                            
                            
                            2007Amount
                            
                            %
                            
                            
                            Amount
                            
                            
                            %(Dollars
      in thousands)Residential
      mortgage loans:Construction
                            
                            $
                            1,568
                            
                            
                            
                            1.3
                            %
                            
                            $
                            4,796
                            
                            
                            
                            3.2
                            %Total residential mortgage
      loans
                            
                            
                            1,568
                            
                            
                            
                            1.3
                            
                            
                            
                            4,796
                            
                            
                            
                            3.2Commercial
      loans and leases:Real
      estate secured
                            
                            
                            10,509
                            
                            
                            
                            9.0
                            
                            
                            
                            16,815
                            
                            
                            
                            11.1Non-Real Estate
                            
                            
                            16,731
                            
                            
                            
                            14.3
                            
                            
                            
                            19,610
                            
                            
                            
                            13.0Standby Letters of
      Credit
                            
                            
                            2,384
                            
                            
                            
                            2.0
                            
                            
                            
                            1,416
                            
                            
                            
                            0.9Construction
                            
                            
                            30,639
                            
                            
                            
                            26.2
                            
                            
                            
                            49,727
                            
                            
                            
                            33.0Total commercial loans and
      leases
                            
                            
                            60,263
                            
                            
                            
                            51.5
                            
                            
                            
                            87,568
                            
                            
                            
                            58.0Consumer
      loans:Home
      equity loans
                            
                            
                            46,089
                            
                            
                            
                            39.4
                            
                            
                            
                            47,911
                            
                            
                            
                            31.7Real Estate
Secured
                            
                            
                            32
                            
                            
                            
                            0.1
                            
                            
                            
                            42
                            
                            
                            
                            0.1Non-Real Estate
                            
                            
                            7,179
                            
                            
                            
                            6.1
                            
                            
                            
                            7,845
                            
                            
                            
                            5.2Construction
                            
                            
                            1,926
                            
                            
                            
                            1.6
                            
                            
                            
                            2,720
                            
                            
                            
                            1.8Total consumer
      loans
                            
                            
                            55,226
                            
                            
                            
                            47.2
                            
                            
                            
                            58,518
                            
                            
                            
                            38.8Total Unfunded
      Commitments
                            
                            $
                            117,057
                            
                            
                            
                            100.0
                            %
                            
                            $
                            150,882
                            
                            
                            
                            100.0
                            %





Loan
Maturities.  The following table sets forth certain information
at December 31, 2008 regarding the dollar amount of loans maturing in the
Company’s portfolio based on their maturity and repricing terms, including
scheduled repayments of principal.  Demand loans, loans having no
stated schedule of repayments and no stated maturity, and overdrafts are
reported as due in one year or less.  The table does not include any
estimate of prepayments which significantly shorten the average life of mortgage
loans and may cause the Company’s repayment experience to differ from that shown
below.  Loan balances are net of construction loans in
process.  Lease balances are included in other loans.





Due One
                  Year or
                  Less
                
                
                Due After 1
                  Through 5 Years
                  After December
                  31, 2008
                
                
                Due After 5 or
                  More Years After
                  December 31, 2008
                
                
                Total(In
      thousands)Residential
      real estate loans
                
                $
                26,698
                
                
                $
                67,117
                
                
                $
                44,790
                
                
                $
                138,605Commercial
      real estate, business and other loans
                
                
                260,686
                
                
                
                292,716
                
                
                
                65,364
                
                
                
                618,766Total
                
                $
                287,384
                
                
                $
                359,833
                
                
                $
                110,154
                
                
                $
                757,371





The
following table sets forth at December 31, 2008 the dollar amount of all loans
due one year or more after December 31, 2008 which have predetermined interest
rates and have floating or adjustable interest rates.





Predetermined
                    Rates
                  
                  
                  Floating
      or
                    Adjustable
      Rates(In
      thousands)Residential
      real estate loans
                  
                  $
                  81,598
                  
                  
                  $
                  30,310Commercial
      real estate, business andother
      loans
                  
                  
                  248,071
                  
                  
                  
                  110,008Total
                  
                  $
                  329,669
                  
                  
                  $
                  140,318


4





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





Originations, Purchases and Sales of
Loans.  The Bank generally has authority to originate and
purchase loans secured by real estate located throughout the state of North
Carolina and the United States.  Consistent with its emphasis on being
a community-oriented financial institution, the Bank concentrates its lending
activities in its market area.  The Bank has not participated in
sub-prime lending activities.





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, 2008, 2007 and 2006,
these transactions totaled $41.1 million, $42.2 million and $18.4 million,
respectively.  Such loans are sold to or exchanged with the Federal
Home Loan Mortgage Corporation (“FHLMC”, also known as “Freddie
Mac”).  The Bank generally retains servicing on loans sold or
exchanged to FHLMC.





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





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





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


5





The Bank
makes a loan commitment on single-family residential mortgage loans 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 95% 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 generally
limits the loan-to-value ratio on multi-family residential real estate loans to
85%, although in limited circumstances the loan-to-value ratio has been
higher.





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 $13.9 million at December 31,
2008.  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 is an originator of single-family,
residential real estate loans in its market area.  At December 31,
2008, single-family, residential mortgage loans, excluding home improvement
loans, totaled $42.3 million, or 5.3% of the Company’s gross loan
portfolio.  The Bank originates fixed-rate mortgage loans at
competitive interest rates.  At December 31, 2008, $26.9 million, or
55.3%, of the Company’s residential mortgage loan portfolio was comprised of
fixed-rate residential mortgage loans.  Generally, the Company retains
fixed-rate mortgages with maturities of 15 years or less while fixed-rate loans
with longer maturities may be retained in portfolio or sold in the secondary
market.  The Bank also offers conventional and government mortgage
loans in its market area, which are underwritten, closed and sold to an outside
investor.





The Bank
also offers adjustable-rate residential mortgage loans.  The
adjustable-rate loans currently offered by the Bank have interest rates which
adjust every one, three, five, seven, or ten 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 plus a stipulated
margin.  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”). The Bank offers adjustable-rate loans that meet
FHLMC underwriting standards, as well as loans that do not meet such
standards.  The Bank’s adjustable-rate single-family residential real
estate loans that do not meet FHLMC standards have a cap of generally 2% on any
increase in the interest rate at any adjustment date, and include a cap on the
maximum interest rate over the life of the loan, which cap generally is 3% to 5%
above the initial rate.  In return for providing a relatively low cap
on interest rate increases over the life of the loan, the Bank’s adjustable-rate
loans provide for a floor on the minimum interest rate over the life of the
loan, which floor generally is the initial rate.  Further, the Bank
generally does not offer “teaser” rates, i.e., initial rates below the
fully indexed rate, on such loans. The adjustable-rate mortgage loans offered by
the Bank that do conform to FHLMC standards have a cap of up to 6% above the
initial rate over the life of a loan and include a floor.  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, 2008, $21.7
million, or 44.7%, 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





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 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 6 to 18 months.  Such loans are offered on a fixed-rate or
adjustable-rate basis.  Interest rates on residential construction
loans made to the owner/occupant have interest rates during the construction
period of 0.5% or more above the rate offered by the Bank on the permanent loan
product selected by the borrower.  Upon completion of construction,
the permanent loan rate will be set at the rate then offered by the Bank on that
permanent loan product, not to exceed the predetermined permanent rate
cap.  Interest rates on residential construction loans to builders are
set at the prime rate plus a margin of between 0% and 1% and adjust either
monthly or daily.  Interest rates on commercial construction loans are
generally based on the prime rate plus a negotiated margin of between 0% and 1%
and adjust either monthly or daily, with construction terms generally not
exceeding 18 months.  Advances are made on a percentage of completed
basis. The Bank has restricted originating speculative construction loans, and
has limited most new construction lending to those with contracts or pre-sales
only.  At December 31, 2008, residential and commercial construction
loans totaled $4.7 million and $172.4 million, respectively, which amounted to
0.6% and 21.8%, respectively, of the Company’s gross loan
portfolio.





Prior to
making a commitment to fund a loan, the Bank requires an appraisal of the
property by appraisers approved by the Board of Directors for loans in excess of
$250,000.  For loans up to $250,000, the Bank requires an evaluation
of the property by qualified Bank personnel, or in certain cases it may require
an outside appraisal by an approved appraiser.  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 0.0% to 1.25% construction loan fee for speculative builder
loans.  For construction loans to owner-occupants, the Bank generally
charges a 0.0% to 1.0% construction loan fee.  For residential
construction loans, the Bank generally charges a commitment fee ranging from
$275 to $500.





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





Multi-Family Residential and
Commercial Real Estate Lending.   The Bank originates
commercial real estate loans, as well as a limited amount of multi-family
residential real estate loans, generally limiting such originations to loans
secured by properties in its primary market area and to borrowers with whom it
has other loan relationships.  The Company’s multi-family residential
loan portfolio consists primarily of loans secured by small apartment buildings,
and the commercial real estate loan portfolio includes loans to finance the
acquisition of small office buildings and commercial and industrial buildings
with a preference to owner occupied.  Such loans generally range in
size from $100,000 to $2.0 million.  At December 31, 2008,
multi-family residential and commercial real estate loans totaled $1.6 million
and $414.7 million, respectively, which amounted to 0.2% and 52.4%,
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
Journalplus a negotiated
margin of between 0% and 1% for shorter term loans, or on a fixed-rate basis
with interest calculated on a 15 to 25-year amortization schedule generally with
a balloon payment due after three to seven years.


7





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





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





As a
commercial bank, the Bank originates commercial business loans.  The
Bank originates commercial business loans to small and medium sized businesses
in its market area. The Bank’s commercial borrowers are generally small
businesses engaged in manufacturing, distribution or retailing, or service
professionals in healthcare, accounting and law.  Commercial business
loans are generally made to finance the purchase of inventory, new or used
equipment or commercial vehicles, to support trading assets and for short-term
working capital.  Such loans generally are secured by equipment and
inventory, and, if possible, cross-collateralized by a real estate mortgage,
although commercial business loans are sometimes granted on an unsecured
basis.  Such loans generally are made for terms of five years or less,
depending on the purpose of the loan and the collateral, with loans to finance
operating expenses made for one year or less, with interest rates that typically
either adjust daily at a rate equal to the prime rate as stated in The Wall Street
Journal plus a margin of between 0% and 2% or at a negotiated fixed
rate.  Generally, commercial loans are made in amounts ranging between
$5,000 and $5,000,000.  At December 31, 2008, commercial business
loans totaled $40.5 million, or 5.1% of the Company’s gross loan
portfolio.





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





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





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


8





Consumer
Lending.  In recent years, the Bank has also focused on
originating consumer loans.  The consumer loans originated by the Bank
include automobile loans, certificate of deposit loans, home equity loans and
miscellaneous other consumer loans, including unsecured loans.  At
December 31, 2008, consumer loans totaled $103.7 million, or 13.1% of the
Company’s gross loan portfolio.





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





The Bank
generally makes certificate of deposit loans for up to 90% of the depositor’s
account balance, but may make a loan of up to 100% of the depositor’s account
balance subject to approval by the credit administrator.  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, 2008, loans on certificates of deposit totaled
$1.4 million, or 0.2% of the Company’s gross loan portfolio.





At
December 31, 2008, the Company had approximately $43.2 million in home equity
line of credit loans, representing approximately 5.4% 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 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 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 residential mortgage
loans for a local credit union.  The Bank receives a 1% origination
fee for each loan as well as an annual servicing fee of 0.375% of the loan
amount.  All of these loans are funded and closed in the name of the
credit union.  The Bank has explored the possibility of developing
similar arrangements with other institutions, although none are currently
planned.





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


9





Loans
generally are placed on nonaccrual status, and accrued but unpaid interest is
reversed, when, in management’s judgment, it is determined that the
collectibility of interest, but not necessarily principal, is
doubtful.  Generally, this occurs when payment is delinquent in excess
of 90 days.  Consumer loans that have become more than 180 days past
due are generally charged off, or a specific allowance may be provided for any
expected loss.  All other loans are charged off when management
concludes that they are uncollectible.  See Notes 1 and 4 of Notes to
Consolidated Financial Statements and Management’s Discussion and Analysis of
Financial Condition and Results of Operations in the 2008 Annual Report filed as
Exhibit 13 hereto for additional information.





Real
estate acquired by the Bank as a result of foreclosure is classified as real
estate acquired through foreclosure until such time as it is sold and is
recorded at the lower of the estimated fair value (less estimated costs to sell)
of the underlying real estate or the carrying amount of the
loan.  Costs relating to holding or improving such real estate are
charged against income in the current period.  Any required write-down
of the loan to its fair value less estimated selling costs upon foreclosure is
charged against the allowance for loan and lease losses.  See
Note 1 of Notes to Consolidated Financial Statements and Management’s
Discussion and Analysis of Financial Condition and Results of Operations in the
2008 Annual Report filed as Exhibit 13 hereto for additional
information.





The
following table sets forth information with respect to the Bank’s nonperforming
assets at the dates indicated.




At December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004(Dollars
      in thousands)Loans
      accounted for on a nonaccrual basis:Residential
      mortgage:Single-family
                  
                  $
                  382
                  
                  
                  $
                  798
                  
                  
                  $
                  934
                  
                  
                  $
                  1,362
                  
                  
                  $
                  814Commercial
      real estate (1)
                  
                  
                  13,458
                  
                  
                  
                  6,588
                  
                  
                  
                  1,274
                  
                  
                  
                  555
                  
                  
                  
                  1,241Commercial
      business
                  
                  
                  51
                  
                  
                  
                  26
                  
                  
                  
                  79
                  
                  
                  
                  220
                  
                  
                  
                  49Consumer
                  
                  
                  1,111
                  
                  
                  
                  143
                  
                  
                  
                  453
                  
                  
                  
                  122
                  
                  
                  
                  245Total
      nonperforming loans
                  
                  $
                  15,002
                  
                  
                  $
                  7,555
                  
                  
                  $
                  2,740
                  
                  
                  $
                  2,259
                  
                  
                  $
                  2,349Percentage
      of total loans, net
                  
                  
                  2.01
                  %
                  
                  
                  0.99
                  %
                  
                  
                  0.36
                  %
                  
                  
                  0.32
                  %
                  
                  
                  0.37
                  %Real
      estate owned
                  
                  $
                  7,711
                  
                  
                  $
                  1,602
                  
                  
                  $
                  634
                  
                  
                  $
                  14
                  
                  
                  $
                  89


________________________


(1)
Includes three restructured loans totaling $4.3 million at December 31, 2008,
pursuant to SFAS No. 15.





During
the year ended December 31, 2008, additional gross interest income of
approximately $624,000 would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current throughout this
period.





Aside
from the loans classified as nonaccrual, over 90 days past due, or restructured
loans, there were no loans at December 31, 2008, 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 10 loans totaling $830,000 which were
accruing interest and contractually over 90 days past due at December 31,
2008.  During the year ended December 31, 2008, additional gross
interest income of approximately $22,000 was recorded on these
loans.





Based on
an impairment analysis of the Bank’s portfolio, there were five loans classified
as impaired under SFAS No. 114 or 118 with total impairment of $1.6 million as
of December 31, 2008, and the Bank has established specific allowance for loan
losses for this impairment accordingly.  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.  See Notes 1 and 4 of Notes to
Consolidated Financial Statements and Management’s Discussion and Analysis of
Financial Condition and Results of Operation in the 2008 Annual Report filed as
Exhibit 13 hereto for additional information.


10





At
December 31, 2008, the Company had $15.0 million of nonaccrual loans, consisting
of six single-family residential mortgage loans totaling $382,000; twenty single
family residential commercial construction loans totaling $4.2 million; nine
commercial residential real estate term loans totaling $3.1 million; six
commercial non-residential real estate term loans totaling $5.6 million; four
commercial land loans totaling $536,000; three commercial business loans
totaling $51,000 and 12 consumer loans totaling $1.1 million.





At
December 31, 2008, the Bank had $7.7 million of real estate owned, which
consisted of 15 single-family residences, 16 vacant lots, one residential
subdivision containing raw land and 46 developed lots, one land loan and one
commercial property. See Note 1 of Notes to Consolidated Financial
Statements and Management’s Discussion and Analysis of Financial Condition and
Results of Operation in the 2008 Annual Report filed as Exhibit 13 hereto for
additional information.





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 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 special
mention, substandard or doubtful require a bank to establish general allowances
for loan losses.  If an asset or portion thereof is classified as
loss, a bank must either establish a specific allowance for loss in the amount
of the portion of the asset classified as 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, 2008, the Company had $57.9 million of classified assets, including $29.1
million classified as special mention, $27.3 million classified as substandard,
none classified as doubtful and $1.5 million classified as loss; compared to
$44.2 million of classified assets, including $30.6 million classified as
special mention, $12.7 million classified as substandard, none classified as
doubtful and $870,000 classified as loss at December 31, 2007.





Allowance for Loan and Lease Losses
and Unfunded Loan Commitments.  The Bank maintains both general
and specific allowances for loan and lease losses and an allowance for unfunded
loan commitments (collectively, the “allowance for credit losses”) 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 credit losses 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 credit
losses.





The Bank
uses a variety of modeling and estimation tools for measuring its credit risk,
which are used in developing the allowance for credit losses.  The
factors supporting the allowance for credit losses do not diminish the fact that
the entire allowance for credit losses is available to absorb losses in the loan
and leases portfolio and the unfunded loan commitment portfolio,
respectively.  The Bank’s principal focus is on maintaining the
adequacy of the total allowance for credit losses.  Based on the
overall credit quality of the loan and lease receivable portfolio, the Bank
believes the current level of its allowance for credit losses is
adequate.  However, future additions to the allowance for credit
losses may be necessary based on changes in economic conditions and other
factors.





See
Notes 1 and 4 of Notes to Consolidated Financial Statements and
Management’s Discussion and Analysis of Financial Condition and Results of
Operation in the 2008 Annual Report filed as Exhibit 13 hereto for additional
information regarding lending activities and the allowance for credit
losses.


11


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





Allowance for Loan
                  and Lease Losses
                
                
                Allowance for
                  Unfunded Loan
                  Commitments
                
                
                Allowance for
                  Credit Losses(Dollars
      in thousands)Balance
      at December 31, 2003
                
                $
                7,634
                
                
                $
                —
                
                
                $
                7,634Provision
      for credit losses
                
                
                968
                
                
                
                —
                
                
                
                968Loans
      and Leases charged-off
                
                
                (302
                )
                
                
                —
                
                
                
                (302
                )Loans
      and Leases recovered
                
                
                43
                
                
                
                —
                
                
                
                43Net
      (charge-offs)/recoveries
                
                
                (259
                )
                
                
                —
                
                
                
                (259
                )Balance
      at December 31, 2004
                
                
                8,343
                
                
                
                —
                
                
                
                8,343Balance
      at December 31, 2004
                
                
                8,343
                
                
                
                —
                
                
                
                8,343Provision
      for credit losses
                
                
                602
                
                
                
                1,109
                
                
                
                1,711Loans
      and Leases charged-off
                
                
                (848
                )
                
                
                —
                
                
                
                (848
                )Loans
      and Leases recovered
                
                
                16
                
                
                
                —
                
                
                
                16Net
      (charge-offs)/recoveries
                
                
                (832
                )
                
                
                —
                
                
                
                (832
                )Balance
      at December 31, 2005
                
                
                8,113
                
                
                
                1,109
                
                
                
                9,222Balance
      at December 31, 2005
                
                
                8,113
                
                
                
                1,109
                
                
                
                9,222Provisions
      for credit losses
                
                
                1,277
                
                
                
                (344
                )
                
                
                933Loans
      and Leases charged-off
                
                
                (342
                )
                
                
                —
                
                
                
                (342
                )Loans
      and Leases recovered
                
                
                110
                
                
                
                —
                
                
                
                110Net
      (charge-offs)/recoveries
                
                
                (232
                )
                
                
                —
                
                
                
                (232
                )Balance
      at December 31, 2006
                
                
                9,158
                
                
                
                765
                
                
                
                9,923Balance
      at December 31, 2006
                
                
                9,158
                
                
                
                765
                
                
                
                9,923Provisions
      for credit losses
                
                
                712
                
                
                
                (362
                )
                
                
                350Loans
      and Leases charged-off
                
                
                (421
                )
                
                
                —
                
                
                
                (421
                )Loans
      and Leases recovered
                
                
                37
                
                
                
                —
                
                
                
                37Net
      (charge-offs)/recoveries
                
                
                (384
                )
                
                
                —
                
                
                
                (384
                )Balance
      at December 31, 2007
                
                
                9,486
                
                
                
                403
                
                
                
                9,889Balance
      at December 31, 2007
                
                
                9,486
                
                
                
                403
                
                
                
                9,889Provisions
      for credit losses
                
                
                4,107
                
                
                
                (63
                )
                
                
                4,044Loans
      and Leases charged-off
                
                
                (2,168
                )
                
                
                —
                
                
                
                (2,168
                )Loans
      and Leases recovered
                
                
                193
                
                
                
                —
                
                
                
                193Net
      (charge-offs)/recoveries
                
                
                (1,975
                )
                
                
                —
                
                
                
                (1,975
                )Balance
      at December 31, 2008
                
                $
                11,618
                
                
                $
                340
                
                
                $
                11,958


12


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





At December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Amount
                  
                  
                  Percent of
                    Loans in
                    Category
                    to Total
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent of
                    Loans in
                    Category
                    to Total
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent of
                    Loans in
                    Category
                    to Total
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent of
                    Loans in
                    Category
                    to Total
                    Loans
                  
                  
                  Amount
                  
                  
                  Percent of
                    Loans in
                    Category
                    to Total
                    Loans(Dollars
      in thousands)Allowance
      for Loan and Lease Losses:Residential
      mortgage
                  
                  $
                  510
                  
                  
                  
                  4.4
                  %
                  
                  $
                  510
                  
                  
                  
                  6.7
                  %
                  
                  $
                  510
                  
                  
                  
                  9.5
                  %
                  
                  $
                  510
                  
                  
                  
                  9.7
                  %
                  
                  $
                  1,034
                  
                  
                  
                  11.3
                  %Commercial
      (1)(2)
                  
                  
                  10,505
                  
                  
                  
                  90.4
                  
                  
                  
                  7,694
                  
                  
                  
                  80.8
                  
                  
                  
                  7,309
                  
                  
                  
                  77.6
                  
                  
                  
                  6,279
                  
                  
                  
                  77.7
                  
                  
                  
                  6,362
                  
                  
                  
                  74.6Consumer
                  
                  
                  603
                  
                  
                  
                  5.2
                  
                  
                  
                  1,282
                  
                  
                  
                  12.5
                  
                  
                  
                  1,339
                  
                  
                  
                  12.9
                  
                  
                  
                  1,324
                  
                  
                  
                  12.6
                  
                  
                  
                  947
                  
                  
                  
                  14.1Total
      allowance for loan and lease losses
                  
                  $
                  11,618
                  
                  
                  
                  100.0
                  %
                  
                  $
                  9,486
                  
                  
                  
                  100.0
                  %
                  
                  $
                  9,158
                  
                  
                  
                  100.0
                  %
                  
                  $
                  8,113
                  
                  
                  
                  100.0
                  %
                  
                  $
                  8,343
                  
                  
                  
                  100.0
                  %Allowance
      for Unfunded Loan Commitments:Mortgage
                  
                  $
                  0
                  
                  
                  
                  0.0
                  %
                  
                  $
                  0
                  
                  
                  
                  0.0
                  %
                  
                  $
                  20
                  
                  
                  
                  2.6
                  %
                  
                  $
                  57
                  
                  
                  
                  5.1
                  %
                  
                  $
                  0
                  
                  
                  
                  0.0
                  %Commercial
                  
                  
                  121
                  
                  
                  
                  35.6
                  
                  
                  
                  163
                  
                  
                  
                  40.4
                  
                  
                  
                  431
                  
                  
                  
                  56.4
                  
                  
                  
                  684
                  
                  
                  
                  61.7
                  
                  
                  
                  0
                  
                  
                  
                  0.0Consumer
                  
                  
                  219
                  
                  
                  
                  64.4
                  
                  
                  
                  240
                  
                  
                  
                  59.6
                  
                  
                  
                  314
                  
                  
                  
                  41.0
                  
                  
                  
                  368
                  
                  
                  
                  33.2
                  
                  
                  
                  0
                  
                  
                  
                  0.0Total
      allowance for unfunded loan commitments (3)
                  
                  $
                  340
                  
                  
                  
                  100.0
                  %
                  
                  $
                  403
                  
                  
                  
                  100.0
                  %
                  
                  $
                  765
                  
                  
                  
                  100.0
                  %
                  
                  $
                  1,109
                  
                  
                  
                  100.0
                  %
                  
                  $
                  0
                  
                  
                  
                  0.0
                  %Combined
      total allowance for credit losses
                  
                  $
                  11,958
                  
                  
                  
                  
                  
                  
                  $
                  9,889
                  
                  
                  
                  
                  
                  
                  $
                  9,923
                  
                  
                  
                  
                  
                  
                  $
                  9,222
                  
                  
                  
                  
                  
                  
                  $
                  8,343


_______________


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


(2)
            Includes
      $1.6 million of specific allowance for loan losses on five commercial real
      estate loans.


(3)
            Recorded
      as other liabilities in the consolidated statements of financial
      condition.


13


Investment
Activities





General.  Interest
income from mortgage-backed securities and investment securities generally
provides the second largest source of income to the Company after interest on
loans.  The Bank’s Board of Directors has authorized investment in
U.S. Government and agency securities, state government obligations, municipal
securities, obligations of the Federal Home Loan Bank (“FHLB”) and
mortgage-backed securities.  The Bank’s objective is to use such
investments to reduce credit risk and provide liquidity.  At December
31, 2008, the Company’s mortgage-backed securities and investment securities
portfolio amounted to $32.8 million and $36.6 million,
respectively.  At such date, the Company had an unrealized gain of
$1.2 million, 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 an analysis on mortgage-backed securities and investment
securities on a quarterly basis to determine the impact on earnings and market
value under various interest rate scenarios 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, 2008, the Company’s
mortgage-backed securities amounted to $32.8 million, or 3.7% 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 government sponsored entities such as FHLMC, the Federal National
Mortgage Association (“FNMA”, also known as “Fannie Mae”) and the Government
National Mortgage Association (“GNMA”, also known as “Ginnie Mae”) 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, 2008, 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, their securities are considered to be good quality investments with
marginal 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
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, 2008, mortgage-backed securities with an amortized cost of $31.2
million and a carrying value of $32.0 million were held as available for sale,
and mortgage-backed securities with an amortized cost of $832,000 and a carrying
value of $832,000 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, 2008, the Bank’s mortgage-backed securities had a weighted average yield of
5.30%.  See Notes 1 and 3 of the Notes to Consolidated Financial
Statements and Management’s Discussion and Analysis of Financial Condition and
Results of Operation in the 2008 Annual Report filed as Exhibit 13 hereto for
additional information.


14





At
December 31, 2008, the average contractual maturity of the Company’s fixed-rate
mortgage-backed securities available-for-sale was approximately 23.8 years,
while the average contractual maturity of mortgage-backed securities held for
investment was approximately 4.7 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, 2008, the Company’s entire portfolio of
investment securities was classified available for sale and amounted to $36.2
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, 2008, the estimated average life of
the Company’s investment securities portfolio was approximately 1.2
years.  In addition, at December 31, 2008, the Company had $3.7
million of FHLB stock.





Equity
Securities.The Company’s equity securities consist of shares
of restricted common stock of Triangle Capital Corporation (NASDAQ: TCAP)
received in 2007 upon completion the TCAP public offering.  Prior to
the public offering, the Company was a 2.2% limited partner in the Triangle
Mezzanine Fund, LLLP, with a limited investment of $500,000.  In the
public offering, TCAP acquired the Triangle Mezzanine Fund, LLLP, and the
limited partners received shares of TCAP restricted common stock in amounts
equivalent to their limited investment in the Triangle Mezzanine Fund,
LLLP.  TCAP is a specialty finance company organized to provide
customized financing solutions to lower middle market companies located
throughout the United States, with an emphasis on the Southeast.  At
December 31, 2008, the TCAP equity securities owned by the Company had a market
value of approximately $344,000.





The
following table sets forth the carrying value of the Company’s investment,
mortgage-backed, and  equity securities portfolio at the dates
indicated.  See Notes 1 and 2 of the Notes to Consolidated Financial
Statements and Management’s Discussion and Analysis of Financial Condition and
Results of Operation in the 2008 Annual Report filed as Exhibit 13 hereto for
additional information.





At December 31,2008
                      
                      
                      2007
                      
                      
                      2006(In
      thousands)Securities
      available for sale:U.S.
      government and agency securities
                      
                      $
                      36,220
                      
                      
                      $
                      48,651
                      
                      
                      $
                      56,454Mortgage-backed
      securities
                      
                      
                      31,995
                      
                      
                      
                      37,828
                      
                      
                      
                      35,067Equity
      securities
                      
                      
                      344
                      
                      
                      
                      413
                      
                      
                      
                      —Total
                      
                      $
                      68,559
                      
                      
                      $
                      86,892
                      
                      
                      $
                      91,521Securities
      held to maturity:FHLB
      stock
                      
                      $
                      3,659
                      
                      
                      $
                      3,210
                      
                      
                      $
                      1,933Mortgage-backed
      securities
                      
                      
                      832
                      
                      
                      
                      1,292
                      
                      
                      
                      1,663Total
                      
                      $
                      4,491
                      
                      
                      $
                      4,502
                      
                      
                      $
                      3,596


15





The
following table sets forth the scheduled maturities, carrying values, amortized
cost and average yields for the Company’s investment securities and
mortgage-backed securities portfolio at December 31, 2008.





One
      Year or Less
                
                
                One
      to Five Years
                
                
                Five
      to Ten Years
                
                
                More
      than Ten Years
                
                
                Total
      Investment PortfolioCarrying
                  Value
                
                
                Average
                  Yield
                
                
                Carrying
                  Value
                
                
                Average
                  Yield
                
                
                Carrying
                  Value
                
                
                Average
                  Yield
                
                
                Carrying
                  Value
                
                
                Average
                  Yield
                
                
                Carrying
                  Value
                
                
                Amortized
                  Cost
                
                
                Average
                  Yield(Dollars
      in thousands)Securities
      availablefor
      sale:U.S.
      governmentand
      agencysecurities
                
                $
                20,491
                
                
                
                4.66
                %
                
                $
                15,729
                
                
                
                4.71
                %
                
                $
                0
                
                
                
                0.00
                %
                
                $
                0
                
                
                
                0.00
                %
                
                $
                36,220
                
                
                $
                34,937
                
                
                
                4.68
                %Mortgage-backed
      securities
                
                
                0
                
                
                
                0.00
                
                
                
                608
                
                
                
                6.25
                
                
                
                1,201
                
                
                
                6.18
                
                
                
                30,185
                
                
                
                5.28
                
                
                
                31,995
                
                
                
                31,167
                
                
                
                5.33Securities
      held tomaturity:FHLB
      stock (1)
                
                
                0
                
                
                
                0.00
                
                
                
                0
                
                
                
                0.00
                
                
                
                0
                
                
                
                0.00
                
                
                
                3,659
                
                
                
                0.00
                
                
                
                3,659
                
                
                
                3,659
                
                
                
                0.00Mortgaged-backed
      securities
                
                
                0
                
                
                
                0.00
                
                
                
                832
                
                
                
                4.00
                
                
                
                0
                
                
                
                4.00
                
                
                
                0
                
                
                
                0.00
                
                
                
                832
                
                
                
                832
                
                
                
                4.00Equity
      securities
                
                
                344
                
                
                
                14.12
                
                
                
                0
                
                
                
                0.00
                
                
                
                0
                
                
                
                0.00
                
                
                
                0
                
                
                
                0.00
                
                
                
                344
                
                
                
                505
                
                
                
                14.12Total
                
                $
                20,835
                
                
                
                4.82
                %
                
                $
                17,169
                
                
                
                4.73
                %
                
                $
                1,201
                
                
                
                6.18
                %
                
                $
                33,844
                
                
                
                4.71
                %
                
                $
                73,050
                
                
                $
                71,100
                
                
                
                4.77
                %


_______________


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


16


Deposit
Activity and Other Sources of Funds





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





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





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





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





At December 31,2008
                
                
                2007
                
                
                2006Amount
                
                
                Weighted
                  Average
                  Rate
                
                
                Amount
                
                
                Weighted
                  Average
                  Rate
                
                
                Amount
                
                
                Weighted
                  Average
                  Rate(Dollars
      in thousands)Demand
      accounts:Checking
                
                $
                208,923
                
                
                
                0.22
                %
                
                $
                227,601
                
                
                
                0.97
                %
                
                $
                239,251
                
                
                
                1.03
                %Money market
                
                
                14,445
                
                
                
                0.20
                
                
                
                16,047
                
                
                
                2.22
                
                
                
                25,471
                
                
                
                2.65Savings
      accounts
                
                
                26,554
                
                
                
                0.38
                
                
                
                17,498
                
                
                
                0.15
                
                
                
                18,481
                
                
                
                0.15Total
                
                $
                249,922
                
                
                
                0.24
                %
                
                $
                261,146
                
                
                
                0.99
                %
                
                $
                283,203
                
                
                
                1.12
                %Certificate
      accounts:Less than 12 months
      (1)
                
                $
                102,250
                
                
                
                3.13
                %
                
                $
                225,839
                
                
                
                4.58
                %
                
                $
                264,386
                
                
                
                4.97
                %12-14 months (1)
                
                
                266,768
                
                
                
                3.66
                
                
                
                227,626
                
                
                
                4.94
                
                
                
                170,786
                
                
                
                4.8215-72 months (1)
                
                
                97,487
                
                
                
                3.95
                
                
                
                46,759
                
                
                
                4.30
                
                
                
                81,813
                
                
                
                4.11Total
                
                
                466,505
                
                
                
                3.61
                
                
                
                500,224
                
                
                
                4.72
                
                
                
                516,985
                
                
                
                4.78Total
      deposits
                
                $
                716,427
                
                
                
                2.43
                %
                
                $
                761,370
                
                
                
                3.44
                %
                
                $
                800,188
                
                
                
                3.48
                %


_______________


(1)
            Original
      term.





See Note
6 of the Notes to Consolidated Financial Statements and Management’s Discussion
and Analysis of Financial Condition and Results of Operation in the 2008 Annual
Report filed as Exhibit 13 hereto for additional information.


17


The
following table indicates the amount of the Company’s certificates of deposit of
$100,000 or more by time remaining until maturity as of December 31,
2008.  At such date, such deposits represented 28.9% of total deposits
and had a weighted average rate of 3.79%.





Maturity Period
                      
                      (In thousands)Three months or less
                      
                      $
                      452Over three months
                      
                      
                      6,201Over six through 12 months
                      
                      
                      129,135Over 12 months
                      
                      
                      71,314Total
                      
                      $
                      207,102





At
December 31, 2008, U.S. Agency Bonds with an amortized cost of $12.8 million
were pledged as collateral for deposits from public entities and repurchase
agreements.





Borrowings. Deposits
historically have been the primary source of funds for the Bank’s lending,
investment and general operating activities.  The Bank is authorized,
however, to use advances from the FHLB of Atlanta to supplement its supply of
lendable funds and to meet deposit withdrawal requirements.  The FHLB
of Atlanta functions as a central reserve bank providing credit for savings
institutions and certain other member financial institutions.  As a
member of the FHLB System, the Bank is required to own stock in the FHLB of
Atlanta and is authorized to apply for advances.  Advances are
pursuant to several different programs, each of which has its own interest rate
and range of maturities.  The FHLB capital stock requirement is based
on the sum of a membership stock component totaling 0.20% of the Bank’s total
assets plus an activity-based stock component of 4.5% of outstanding FHLB
advances.  Advances from the FHLB of Atlanta are secured by the Bank’s
stock in the FHLB of Atlanta and other eligible assets.  During the
years ended December 31, 2008, 2007 and 2006, 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.  See Note 9 of the Notes to Consolidated Financial Statements
and Management’s Discussion and Analysis of Financial Condition and Results of
Operation in the 2008 Annual Report filed as Exhibit 13 hereto for additional
information.





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





At or for the Year Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006(In
      thousands)Amounts
      outstanding at end of periods:FHLB
      advances
                    
                    $
                    45,000
                    
                    
                    $
                    35,000
                    
                    
                    $
                    6,000Federal
      funds purchased and securities sold underrepurchase
      agreements
                    
                    
                    7,558
                    
                    
                    
                    7,067
                    
                    
                    
                    5,140Rate
      paid on:FHLB
      advances
                    
                    
                    3.01
                    %
                    
                    
                    4.40
                    %
                    
                    
                    5.50
                    %Federal
      funds purchased and securities sold underagreement
      to repurchase
                    
                    
                    0.25
                    %
                    
                    
                    3.38
                    %
                    
                    
                    4.86
                    %Maximum
      amount of borrowings outstanding at any month end:FHLB
      advances
                    
                    
                    53,000
                    
                    
                    
                    40,800
                    
                    
                    
                    31,600Federal
      funds purchased and securities sold underrepurchase
      agreements
                    
                    
                    12,805
                    
                    
                    
                    9,198
                    
                    
                    
                    8,556Approximate
      average short-term borrowings outstandingwith
      respect to:FHLB
      advances
                    
                    
                    45,274
                    
                    
                    
                    9,155
                    
                    
                    
                    11,969Federal
      funds purchased and securities sold underrepurchase
      agreements
                    
                    
                    9,671
                    
                    
                    
                    7,221
                    
                    
                    
                    6,625Approximate
      weighted average rate paid on: (1)FHLB
      advances
                    
                    
                    3.07
                    %
                    
                    
                    5.01
                    %
                    
                    
                    5.27
                    %Federal
      funds purchased and securities sold underrepurchase
      agreements
                    
                    
                    1.81
                    %
                    
                    
                    4.34
                    %
                    
                    
                    4.41
                    %





_________


(1)    Based
on month-end balances.


18





Competition





The
Company faces strong competition in originating real estate, commercial business
and consumer loans and in attracting deposits.  The Bank competes for
real estate and other loans principally on the basis of interest rates, the
types of loans it originates, the deposit products it offers and the quality of
services it provides to borrowers.  The Bank also competes by offering
products which are tailored to the local community, including lease
financing.  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 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.





In
addition, the Bank makes securities brokerage services available through an
affiliation with an independent broker-dealer.





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, 2008, the Bank had 258 full-time and 33 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), Regulation 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, rather
than shareholders.  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 are
applicable to the Bank and Company. This 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.





19


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 under the “CAMELS” 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 4.0%.  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.





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 Office of
the Commissioner of Banks (the “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 the Federal Deposit Insurance Corporation
Improvement Act of 1991 (“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
action provisions.  If an institution’s ratio of tangible capital to
total assets falls below the “critical capital level” established by the
appropriate federal banking regulator, the institution will be subject to
conservatorship or receivership within specified time periods.


20





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




Adequately
                    
                    
                    
                    SignificantlyWell Capitalized
                    
                    Capitalized
                    
                    Undercapitalized
                    
                    UndercapitalizedTotal risk-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%





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





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





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





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


21


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





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





Federal Home Loan Bank
System.  The FHLB System consists of 12 district FHLBs subject
to supervision and regulation by the Federal Housing Finance Board
(“FHFB”).  The FHLBs provide a central credit facility primarily for
member institutions.  As a member of the FHLB of Atlanta, the Bank is
required to acquire and hold shares of capital stock in the FHLB of
Atlanta.  The Bank was in compliance with this requirement with
investment in FHLB of Atlanta stock at December 31, 2008, of $3.7
million.  The FHLB of Atlanta serves as a reserve or central bank for
its member institutions within its assigned district.  It is funded
primarily from proceeds derived from the sale of consolidated obligations of the
FHLB System.  It offers advances to members in accordance with
policies and procedures established by the FHFB and the Board of Directors of
the FHLB of Atlanta.  Long-term advances may only be made for the
purpose of providing funds for residential housing finance, small businesses,
small farms and small agribusinesses.





Reserves.Pursuant
to regulations of the Federal Reserve Board, the Bank must maintain average
daily reserves equal to 3% on transaction accounts of $8.5 million up to $45.8
million, plus 10% on the remainder.  This percentage is subject to
adjustment by the Federal Reserve Board.  Because required reserves
must be maintained in the form of vault cash or in a noninterest bearing account
at a Federal Reserve Bank, the effect of the reserve requirement is to reduce
the amount of the institution’s interest-earning assets.  As of
December 31, 2008, 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 limits set by
the Deposit Insurance Fund of the FDIC.  On October 3, 2008, the
Emergency Economic Stabilization Act of 2008 (the “Stabilization Act”) was
enacted to temporarily raise the basic limit of FDIC insurance coverage from
$100,000 to $250,000 per depositor.  The temporary increase in FDIC
insurance coverage became effective immediately upon enactment.  The
basic deposit insurance limit will return to $100,000 after December 31, 2009,
unless a new law is enacted before then to extend the increased deposit
insurance limits.





The FDIC
has amended its risk-based assessment system 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 a
majority of all insured 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.  During the year ended December 31, 2008, the Bank was
assigned to Risk Category I.





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%.  Assessment rates are
determined by the FDIC and currently range from 5 to 7 basis points annually of
assessable deposits for the healthiest institutions (Risk Category I) to 43
basis points for the riskiest (Risk Category IV).  The FDIC may adjust
assessment rates from one quarter to the next, except that no single adjustment
can exceed 3 basis points.  The Bank’s quarterly Deposit Insurance
Fund assessments during the year ended December 31, 2008 ranged from 1.25 to
1.64 basis points of assessable deposits.


22





The
Reform Act also provided for a one-time credit for eligible insured institutions
based on their assessment base as of December 31, 1996.  Subject to
certain limitations with respect to institutions that are exhibiting weaknesses,
one-time credits are used to offset quarterly assessments until
exhausted.    The Bank’s original one-time assessment credit
was $405,964.  During the year ended December 31, 2008, the Bank used
the remaining $106,622 of its one-time assessment credits to offset March and
June 2008 quarterly assessments, exhausting its one-time assessment
credit.  The Reform Act also provided 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, insured institutions are
required to make payments on bonds issued by the Financing Corporation (“FICO”),
established by the Competitive Equality Banking Act of 1987 to recapitalize the
former Federal Savings & Loan Insurance Corporation (“FSLIC”) deposit
insurance fund.  The Bank’s quarterly FICO payments during the year
ended December 31, 2008 averaged 1.12 basis points of assessable
deposits.





On
October 14, 2008, the FDIC announced the Temporary Liquidity Guarantee Program
(the “TLG Program”) to strengthen confidence and encourage liquidity in the
banking system.  The TLG Program consists of two components: a
temporary guarantee of newly-issued senior unsecured debt (the “Debt Guarantee
Program”) and a temporary unlimited guarantee of funds in noninterest-bearing
transaction accounts at FDIC insured institutions (the “Transaction Account
Guarantee Program”).  All newly-issued senior unsecured debt will be
charged an annual assessment of up to 100 basis points (depending on term)
multiplied by the amount of debt issued and calculated through the date of that
debt or June 30, 2012, whichever is earlier.  The Bank elected to opt
out of the Debt Guarantee Program.  Amounts exceeding the existing
$250,000 deposit insurance limit in noninterest-bearing transaction accounts
will be assessed an annual 10 basis points and collected quarterly through
December 31, 2009.  The Bank elected to participate in the Transaction
Account Guarantee Program and as a result, does not anticipate a material
increase in its deposit insurance premiums.





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 an insured
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.  Management
of the Bank is not aware of any practice, condition or violation that might lead
to termination of its FDIC 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 11.7% of
total deposits at December 31, 2008, 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.


23


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 $13.9 million at December 31,
2008.  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, 2008, the Bank’s largest lending
relationship was a $9.5 million relationship consisting of 16 commercial real
estate loans, one commercial business loan and one consumer loan.  All
loans within this relationship were current and performing in accordance with
their terms at December 31, 2008.





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.





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 Bank Holding Company Act of 1956, as amended (“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.


24





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 BHCA,
and the regulations of the Federal Reserve Board.  As a bank holding
company, the Company is required to file with the Federal Reserve Board annual
reports and such additional information as the Federal Reserve Board may
require, and is subject to regular examinations by the Federal Reserve
Board.  The Federal Reserve Board also has extensive enforcement
authority over bank holding companies, including, among other things, the
ability to assess civil money penalties, to issue cease and desist or removal
orders and to require that a holding company divest subsidiaries, including its
bank subsidiaries.  In general, enforcement actions may be initiated
for violations of law and regulations and unsafe or unsound
practices.





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





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





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


25





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.  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.





The
federal banking agencies are also 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.


26





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 have
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 0.15% applied to the greatest of the institution’s (i) capital stock,
surplus and undivided profits, (ii) investment in tangible property in North
Carolina or (iii) appraised valuation of property in North
Carolina.





For
additional information regarding taxation, see Notes 1 and 10 of Notes to
Consolidated Financial Statements in the 2008 Annual Report filed as Exhibit 13
hereto.





Item 1A. Risk
Factors





Recent
operating results may not be indicative of future operating
results.





The
Company may not be able to sustain its historical rate of growth and it may be
difficult to replicate historical earnings growth. Consequently, historical
results of operations will not necessarily be indicative of future operations.
Various factors, such as economic conditions, regulatory and legislative
considerations, and competition, may also impede the ability to expand market
presence. If the Company experiences a significant decrease in the historical
rate of growth, results of operations and financial condition may be adversely
affected because a high percentage of operating costs are fixed
expenses.





Certain
interest rate movements may impact earnings and asset value.





Since
December 31, 2006, the prime lending rate has decreased from 8.25% to 3.25% at
December 31, 2008. Short-term and intermediate-term market interest rates are
used as a guide to price the Bank’s loans and deposits.  The recent
decrease in such interest rates has had a negative impact on the Bank’s interest
rate spread and net interest margin to date, as a result of the interest
sensitivity of the Bank’s interest-earning assets.  Should short-term
interest rates decline dramatically in the near future, and if rates on the
Bank’s loans and investments reprice downwards faster than the rates on the
Bank’s deposits and borrowings, the Bank could experience more compression of
its interest rate spread and net interest margin, which could have a negative
effect on the Bank’s profitability.





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





27





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.





If
the Bank experiences greater loan losses than anticipated, it will have an
adverse effect on our net income.





While the
risk of nonpayment of loans is inherent in banking, if the Bank experiences
greater nonpayment levels than anticipated, earnings and overall financial
condition, as well as the value of the Company’s common stock, could be
adversely affected.  There is no assurance that monitoring procedures
and policies will reduce certain lending risks or that the allowance for loan
losses will be adequate to cover actual losses. In addition, as a result of the
growth in the loan portfolio, loan losses may be greater than management’s
estimates of the appropriate level for the allowance. Loan losses can cause
insolvency and failure of a financial institution and, in such an event,
shareholders could lose their entire investment. In addition, future provisions
for loan losses could materially and adversely affect profitability. Loan losses
will reduce the loan loss allowance, and reduction in the loan loss allowance
could be restored by an increase in the provision for loan losses. This would
reduce earnings which could have an adverse effect on the stock
price.





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, 2008, the Company had commercial real
estate, commercial construction, commercial business and consumer loans totaling
$414.7 million, $172.4 million, $40.5 million and $103.7 million, respectively,
which represented 52.4%, 21.8%, 5.1% and 13.1%, respectively, of total
loans.  At December 31, 2008, $48.6 million, or 6.1% of total loans,
consisted of residential real estate mortgage loans.





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





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


28





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.”




Weakness
in the markets for residential or commercial real estate, including the
secondary residential mortgage loan markets, could reduce the Company’s net
income and profitability.




Since
2007, the United States has seen softening residential housing markets,
increasing delinquency and default rates, and increasingly volatile and
constrained secondary credit markets have been affecting the mortgage industry
generally. The Company’s financial results may be adversely affected by changes
in real estate values in areas in which it operates. Decreases in real estate
values in these areas could adversely affect the value of property used as
collateral for loans and investments. If poor economic conditions result in
decreased demand for real estate loans, then the Company’s net income and
profits may decrease.




The
declines in home prices in many markets across the United States, along with the
reduced availability of mortgage credit, also may result in increases in
delinquencies and losses in the Bank’s portfolio of loans related to residential
real estate construction and development. Further declines in home prices
coupled with an economic recession and associated rises in unemployment levels
could drive losses beyond that which are provided for in the allowance for loan
losses. In that event, the Company’s earnings could be adversely
affected.




Additionally,
recent weakness in the secondary market for residential lending could have an
adverse impact upon the Company’s profitability. Significant ongoing disruptions
in the secondary market for residential mortgage loans have limited the market
for and liquidity of most mortgage loans other than conforming Fannie Mae,
Freddie Mac and Ginnie Mae loans. The effects of ongoing mortgage market
challenges, combined with the ongoing correction in residential real estate
market prices and reduced levels of home sales, could result in further price
reductions in single family home values, adversely affecting the value of
collateral securing mortgage loans held, mortgage loan originations and gains on
sale of mortgage loans. Continued declines in real estate values and home sales
volumes, and financial stress on borrowers as a result of job losses, or other
factors, could have further adverse effects on borrowers that result in higher
delinquencies and greater charge-offs in future periods, which would adversely
affect the Company’s financial condition or results of operations.





Liquidity
is essential to the Bank’s business and it relies, in part, on external funding
sources to finance a portion of its operations.





Liquidity
is essential to the Bank’s business. Liquidity could be substantially negatively
affected by the inability to access secured lending markets or raise funding in
the long-term or short-term capital markets. Factors that cannot be controlled,
such as disruption of the financial markets or negative views about the
financial services industry generally, could impair the ability to raise
funding. In addition, the ability to raise funding could be impaired if the FHLB
develops a negative perception of the Bank’s long-term or short-term financial
prospects. Such negative perceptions could be developed due to a decline in the
level of business activity, actions regulatory authorities might take, or the
discovery of employee misconduct or illegal activity, among other things. If the
Bank were unable to raise funds using the methods described above, it would
likely need to liquidate unencumbered assets, such as the investment and loan
portfolios, to meet maturing liabilities. The Bank may be unable to sell some of
its assets, or may have to sell assets at a discount from market value, either
of which could adversely affect its operations.


29




The
capital and credit markets have experienced unprecedented levels of
volatility.




During
2008 and continuing into 2009, the capital and credit markets experienced
extended volatility and disruption. In the last six months, the volatility and
disruption reached unprecedented levels. In some cases, the markets produced
downward pressure on stock prices and credit capacity for certain issuers
without regard to those issuers’ underlying financial strength. If these levels
of market disruption and volatility continue, worsen or abate and then arise at
a later date, there can be no assurance that the Company will not experience an
adverse effect on its ability to access capital, its business, its financial
condition, and its results of operations.




In
response to financial conditions affecting the banking system and financial
markets and the potential threats to the solvency of investment banks and other
financial institutions, the United States government has taken unprecedented
actions. These actions include the government-assisted acquisition of certain
investment brokerage firms, the federal conservatorship of Fannie Mae and
Freddie Mac, and a historic bill authorizing the U.S. Treasury to invest in
financial institutions and purchase mortgage loans and mortgage-backed and other
securities from financial institutions for the purpose of stabilizing the
financial markets or particular financial institutions. There can be no
assurance as to when or if the government will further intervene in the
financial sector and what impact government actions will have on the financial
markets. Governmental intervention (or the lack thereof) could materially and
adversely affect the Company’s business, financial condition and results of
operations.





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 eastern, northeastern, southeastern and central
North Carolina, where the Bank’s offices are located.  As of December
31, 2008, 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.  The current recessionary environment has negatively
impacted real estate values, the volume of home sales, unemployment and other
related economic conditions in the markets served by the Company and the
Bank.





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
Commissioner 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 relies heavily on the services of key personnel.





The Bank
is a customer-focused and relationship-driven organization.  The Bank
expects its future growth to be driven in large part by the relationships
maintained with its customers by the executive and other key
officers.  The unexpected loss of services of any executive and other
key officers could have a material adverse effect on operations and possibly
result in reduced revenues and earnings.




The
Company’s common stock is not FDIC insured.




The
Company’s common stock is not a savings or deposit account or other obligation
of the Bank and is not insured by the FDIC, the Deposit Insurance Fund or any
other governmental agency and is subject to investment risk, including the
possible loss of principal.


30





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 non-monetary factors in
evaluating a business combination or a tender or exchange offer.  The
provisions in the Company’s Certificate of Incorporation requiring a
supermajority vote for the approval of certain business combinations and
containing restrictions on acquisitions of the Company’s equity securities
provide that the supermajority voting requirements or acquisition restrictions
do not apply to business combinations or acquisitions meeting specified Board of
Directors approval requirements.  The Certificate of Incorporation
also authorizes the issuance of 1,000,000 shares of preferred stock as well as
additional shares of Common Stock up to a total of 25,000,000 outstanding
shares.  These shares could be issued without stockholder approval on
terms or in circumstances that could deter a future takeover
attempt.





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





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





Item 1B.
Unresolved Staff Comments.  The Company has received no written
comments regarding its periodic or current reports from the staff of the
Securities and Exchange Commission that were issued 180 days or more preceding
the end of its 2008 fiscal year and that remain unresolved.


31





Item
2.Properties





The
following table has the location and information regarding the Bank’s offices at
December 31, 2008.





Year
                            Opened
                          
                          Owned
      or
                            Leased
                          
                          
                          Book
      Value at
                            December
      31,
                            2008
                          
                          
                          Approximate
                            Square
                            Footage(Dollars
      in thousands)Main
      Office:
                            1311
      Carolina Avenue
                            Washington,
      NC
                          1986
                          
                          Owned
                          
                          
                          $
                          702
                          
                          
                          
                          10,200Branch
      Offices:
                            300
      North Market Street
                            Washington,
      NC
                          1959
                          
                          Owned
                          
                          
                          
                          102
                          
                          
                          
                          4,6801328
      John Small Avenue
                            Washington,
      NC
                          2001
                          
                          Leased
                          
                          
                          
                          7
                          
                          
                          
                          1,9162999
      US Hwy. 17S.
                            Chocowinity,
      NC
                          1999
                          
                          **
                          
                          
                          
                          230
                          
                          
                          
                          2,530301
      E. Arlington Boulevard
                            Greenville,
      NC
                          1993
                          
                          Owned
                          
                          
                          
                          259
                          
                          
                          
                          2,600907
      E. Firetower Road
                            Greenville,
      NC
                          2005
                          
                          Owned
                          
                          
                          
                          729
                          
                          
                          
                          2,2451707
      SE. Greenville Blvd
                            Greenville,
      NC
                          2007
                          
                          Owned
                          
                          
                          
                          1,072
                          
                          
                          
                          2,245604
      E. Ehringhaus Street
                            Elizabeth
      City, NC
                          1980
                          
                          Owned
                          
                          
                          
                          119
                          
                          
                          
                          2,5001906
      S. Croatan Street
                            Kill
      Devil Hills, NC
                          2002
                          
                          Leased
                          
                          
                          
                          42
                          
                          
                          
                          2,00047560
      Hwy. 12
                            Buxton,
      NC
                          2005
                          
                          **
                          
                          
                          
                          482
                          
                          
                          
                          2,0292430
      Heritage Street
                            Kinston,
      NC
                          2001
                          
                          Leased
                          
                          
                          
                          24
                          
                          
                          
                          2,1451725
      Glenburnie Road
                            New
      Bern, NC
                          1990
                          
                          Owned
                          
                          
                          
                          257
                          
                          
                          
                          2,600202
      Craven Street
                            New
      Bern, NC
                          1995
                          
                          Leased
                          
                          
                          
                          10
                          
                          
                          
                          2,5002019
      S. Glenburnie Road
                            Crossroads
      Shopping Center
                            New
      Bern, NC
                          2004
                          
                          Leased
                          
                          
                          
                          41
                          
                          
                          
                          43511560
      NC Hwy 55
                            Suite
      11
                            Grantsboro,
      NC
                          2007
                          
                          Leased
                          
                          
                          
                          82
                          
                          
                          
                          1,600241
      Green Street
                            Fayetteville,
      NC
                          1999
                          
                          Owned
                          
                          
                          
                          723
                          
                          
                          
                          9,550705
      Executive Place
                            Fayetteville,
      NC
                          1999
                          
                          Leased
                          
                          
                          
                          26
                          
                          
                          
                          2,200600
      N. Chestnut Street
                            Lumberton,
      NC
                          1999
                          
                          Owned
                          
                          
                          
                          319
                          
                          
                          
                          6,000


32





Year
                    Opened
                  
                  Owned or
                    Leased
                  
                  Book Value at
                    December 31,
                    2008
                  
                  
                  Approximate
                    Square
                    Footage(Dollars in thousands)3000
      N. Elm Street
                    Lumberton,
      NC
                  2001
                  
                  Leased
                  
                  
                  233
                  
                  
                  
                  2,1283103
      N. Main Street
                    Hope
      Mills, NC
                  2004
                  
                  Owned
                  
                  
                  495
                  
                  
                  
                  2,072904
      A West Broad St
                    Dunn,
      NC
                  2007
                  
                  Leased
                  
                  
                  28
                  
                  
                  
                  1,477100
      East Hope Lodge Street
                    Tarboro,
      NC
                  2000
                  
                  Leased
                  
                  
                  11
                  
                  
                  
                  1,350300
      Sunset Avenue
                    Rocky
      Mount, NC
                  1994
                  
                  Owned
                  
                  
                  249
                  
                  
                  
                  4,9482901
      Sunset Avenue
                    Rocky
      Mount, NC
                  2000
                  
                  Owned
                  
                  
                  976
                  
                  
                  
                  5,6351378
      Benvenue Road
                    Rocky
      Mount, NC
                  2000
                  
                  **
                  
                  
                  262
                  
                  
                  
                  5,3763635
      North Halifax Road
                    Rocky
      Mount, NC
                  2000
                  
                  Leased
                  
                  
                  23
                  
                  
                  
                  3964800
      Six Forks Road
                    Six
      Forks III, Suite #115
                    Raleigh,
      NC
                  2004
                  
                  Leased
                  
                  
                  21
                  
                  
                  
                  4,5014215
      University Dr
                    Durham,
      NC
                  2004
                  
                  Leased
                  
                  
                  207
                  
                  
                  
                  2,000Loan
      Production Office:
                    3804
      Peachtree Ave
                    Unit
      200
                    Wilmington,
      NC
                  2007
                  
                  Leased
                  
                  
                  22
                  
                  
                  
                  1,200Credit
      Administration:
                    Creekside
      2
                    220
      Creekside Drive
                    Washington,
      NC
                  2006
                  
                  Owned
                  
                  
                  690
                  
                  
                  
                  10,000Operations
      Center:
                    Creekside
      1
                    220
      Creekside Drive
                    Washington,
      NC
                  2001
                  
                  Owned
                  
                  
                  585
                  
                  
                  
                  10,000First
      South Leasing, LLC:
                    1035
      Director Court
                    Suite
      C
                    Greenville,
      NC
                  2001
                  
                  Leased
                  
                  
                  17
                  
                  
                  
                  1,146


___________


** Lease
land, own building.





The book
value of the Bank’s premises and equipment was $9.0 million at December 31,
2008.  See Notes 1 and 5  to Consolidated Financial
Statements in the 2008 Annual Report filed as Exhibit 13
hereto.


33





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, 2008, 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





No
matters were submitted to a vote of shareholders during the fourth quarter of
the fiscal year covered by this report..





PART
II





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





(a)
            The
      information contained in the sections captioned “Stockholder Information —
      Stock Listing Information” and “— Stock Price Information” in the
      Company’s Annual Report to Stockholders for the Fiscal Year Ended December
      31, 2008 (the “Annual Report”) filed as Exhibit 13 hereto is incorporated
      herein by reference.


(b)
            Not
      applicable.


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




(a)
                    
                    
                    (b)
                    
                    
                    (c)
                    
                    
                    (d)Period
                    
                    Total
                      Number of
                      Shares
                      Purchased(1)
                    
                    
                    Average
                      Price Paid
                      per Share
                    
                    
                    Total Number of
                      Shares Purchased
                      as Part of Publicly
                      Announced Plans
                      Programs
                    
                    
                    Maximum
                      Number of Shares that
                      May Yet Be Purchased
                      Under
                      the Plans or
                      Programs (1)October
      2008
                      Beginning
      date: October 1
                      Ending
      date:  October 31
                    
                    
                    -0-
                    
                    
                    $
                    0.00
                    
                    
                    
                    -0-
                    
                    
                    
                    372,012November
      2008
                      Beginning
      date: November 1
                      Ending
      date:  November 30
                    
                    
                    -0-
                    
                    
                    
                    0.00
                    
                    
                    
                    -0-
                    
                    
                    
                    372,012December  2008
                      Beginning
      date: December 1
                      Ending
      date:  December 31
                    
                    
                    -0-
                    
                    
                    
                    0.00
                    
                    
                    
                    -0-
                    
                    
                    
                    372,012


___________


(1)
Shares may be purchased under a repurchase program announced on January 15,
2008.  Under this program, the Company announced that it may purchase
up to 490,755 shares of its Common Stock.  This program expired on
January 14, 2009.  The Company purchased 118,743 shares of the 490,755
shares previously approved under that plan.





Item
6.Selected
Financial Data





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





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





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


34





Item
7A.Quantitative
and Qualitative Disclosures About Market Risk





The
information contained in the section captioned “Management’s Discussion and
Analysis of Financial Condition and Results of Operation — Market Risk” 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 in the
Annual Report, which are listed under Item 15 herein, are incorporated herein by
reference.





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 2009 Annual Meeting of Stockholders (the “Proxy Statement”) is
incorporated herein by reference.





Item 9A.  Controls
and Procedures





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





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





Management’s
Annual Report on Internal Control Over Financial Reporting





[Letterhead
of First South Bancorp, Inc.]





Management
of First South Bancorp, Inc. and subsidiary (the “Company”) is responsible for
the preparation, integrity, and fair presentation of its published financial
statements as of December 31, 2008, 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
(“COSO”).  Based on this evaluation under the framework in INTERNAL
CONTROL - INTEGRATED FRAMEWORK issued by COSO, management of the Company has
concluded the Company maintained effective internal control over financial
reporting as of December 31, 2008.


35





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, 2008.





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, 2008, 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, 2008, which is included herein.





First
South Bancorp, Inc.


March 5,
2009





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





Attestation
Report of Independent Registered Public Accounting Firm





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





To the
Board of Directors and Stockholders


First
South Bancorp, Inc.


Washington,
North Carolina





We have
audited First South Bancorp, Inc. and Subsidiary’s internal control over
financial reporting as of December 31, 2008, based on criteria established in
Internal Control – Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  First South Bancorp, Inc. and
Subsidiary’s management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting included in the accompanying
Management's Annual Report on Internal Control Over Financial
Reporting.  Our responsibility is to express an opinion on the
company’s internal control over financial reporting based on our
audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  Our audit of internal control over financial
reporting included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, and testing and
evaluating the design and operating effectiveness of internal control based on
the assessed risk.  Our audit also included performing such other
procedures as we considered necessary in the circumstances.  We
believe that our audit provides a reasonable basis for our
opinion.


36


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.





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





In our
opinion, First South Bancorp, Inc. and Subsidiary maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2008, based on criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated statements of financial
condition and the related consolidated statements of operations, changes in
stockholders' equity, and cash flows of First South Bancorp, Inc. and
Subsidiary, and our report dated March 5, 2009, expressed an unqualified
opinion.





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





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





Lexington,
North Carolina


March 5,
2009





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.None.





PART
III





Item
10.Directors,
Executive Officers and Corporate Governance





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 5.05 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.


37





Item
11.Executive
Compensation





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





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, 2008.





(a)
                    
                    
                    (b)
                    
                    
                    (c)Plan category:
                    
                    Number
      of securities to
                      be
      issued upon exercise of
                      outstanding
      options,
                      warrants
      and rights
                    
                    
                    Weighted-average
                      exercise
                      price
      of outstandingoptions,
      warrants
                      andrights
                    
                    
                    Number
      of securities
                      remaining
                      available
      for future issuance
                      under
      equity compensation
                      plans
      (excluding securities
                      reflected
      in column (a))Equity
      compensation plans
                      approved
      by security holders
                    
                    
                    172,295
                    
                    
                    $
                    17.52
                    
                    
                    
                    947,000Equity
      compensation plans not
                      approved
      by security holders
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —Total
                    
                    
                    172,295
                    
                    
                    $
                    17.52
                    
                    
                    
                    947,000





Item
13.Certain
Relationships and Related Transactions and Director
Independence





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





Item
14.  Principal Accountant Fees and Services





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





PART
IV





Item
15.Exhibits
and Financial Statement Schedules





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





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





Reports
of Independent Registered Public Accounting Firms


Consolidated
Statements of Financial Condition as of December 31, 2008 and
2007


38





Consolidated
Statements of Operations for the Years Ended December 31, 2008, 2007 and
2006


Consolidated
Statements of Changes in Stockholder’s Equity for the Years Ended December 31,
2008, 2007 and 2006


Consolidated
Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006
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.
                  
                  Description3.1
                  
                  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 September 27, 2007 (Incorporated
      herein by reference from Exhibit 3.2 to the Company’s Current Report on
      Form 8-K (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))*10.1(c)
                  
                  Amendment
      dated December 18, 2008 to the amended and restated First South Bank and
      First South Bancorp, Inc. Employment Agreement with Thomas A.
      Vann*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))*10.2(a)
                  
                  Amendments
      dated December 18, 2008 to the Change in Control Protective Agreements
      between First South Bank and First South Bancorp, Inc. and Mary R. Boyd,
      Sherry L. Correll and Kristie W. Hawkins*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))*10.3(a)
                  
                  Amendments
      dated December 26, 2008 to the Supplemental Income Agreements, as amended
      and restated, between First South Bank and Sherry L. Correll and Thomas A.
      Vann*10.4
                  
                  Supplemental
      Income Plan Agreements as Amended and Restated December 14, 1995 between
      Home Savings Bank, SSB and Thomas A. Vann and William L. Wall and the 1996
      Amendment Thereto (Incorporated herein by reference from Exhibit 10.6 to
      the Company’s Registration Statement on Form S-1 (File No.
      333-16335))*10.4(a)
                  
                  Amendments
      dated December 26, 2008 to the Supplemental Income Plan Agreements, as
      amended and restated, between First South Bank and Thomas A. Vann and
      William L. Wall*10.5
                  
                  Home
      Savings Bank, SSB Director’s Deferred Compensation Plan Agreements as
      Amended and Restated December 14, 1995 with 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))*


39





10.5(a)
              
              Amendments
      dated December 26, 2008 to the Director’s Deferred Compensation Plan
      Agreements, as amended and restated, between Frederick N. Holscher and
      Thomas A. Vann*10.6
              
              First
      South Bank Director’s Retirement Plan Agreements as Amended and Restated
      December 14, 1995 with 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))*10.6(a)
              
              Amendments
      dated December 26, 2008 to the Director’s Retirement Plan Agreements, as
      amended and restated, between First South Bank and Frederick N. Holscher
      and Thomas A. Vann*10.7
              
              Home
      Savings Bank, SSB Director’s Retirement Payment Agreements as Amended and
      Restated December 14, 1995 with 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))*10.7(a)
              
              Amendments
      dated December 26, 2008 to the Director’s Retirement Payment Agreements,
      as amended and restated, between First South Bank and Frederick N.
      Holscher and Thomas A. Vann.*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))*10.8(a)
              
              Amendment
      dated December 26, 2008 the Director’s Retirement Plan Agreement, as
      amended and restated, between First South Bank an Marshall T.
      Singleton*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
              
              First
      South Bancorp, Inc. 2008 Equity Incentive Plan (Incorporated herein by
      reference from Exhibit 10.1 to the Company’s Registration Statement on
      Form S-8 filed on June 2, 2008 (File No. 0-22219))*10.11
              
              Change-in-Control
      Protective Agreement between First South Bank, First South Bancorp, Inc.
      and J. Randall Woodson dated October 3, 2008 (Incorporated herein by
      reference from Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q
      for the Quarter Ended September 30, 2008 (File No.
    0-22219))*10.12
              
              Change
      in Control Protective Agreement between First South Bank, First South
      Bancorp, Inc. and William L. Wall, as amended and restated April 24, 2008
      (Incorporated herein by reference from Exhibit 10.12 to the Company’s
      Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2008 (File
      No. 0-22219))*10.12(a)
              
              Amendment
      dated December 18, 2008 to the Change in Control Protective Agreement, as
      amended and restated, between First South Bank and First South Bancorp,
      Inc. and William L. Wall*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))10.14
              
              Supplemental
      Income Plan Agreement dated September 5, 2002 between First South Bank and
      Kristie W. Hawkins*10.14(a)
              
              Amendment
      dated December 26, 2008 to the Supplemental Income Plan Agreement between
      First South Bank and Kristie W. Hawkins*10.15
              
              Change
      in Control Protective Agreement dated July 8, 2002 between First South
      Bank and First South Bancorp, Inc. and Paul S. Jaber*10.15(a)
              
              Amendment
      dated December 18, 2008 to the Change in Control Protective Agreement
      between First South Bank and First South Bancorp, Inc. and Paul S.
      Jaber*13
              
              Annual
      Report to Stockholders for the Fiscal Year Ended December 31,
      200821
              
              Subsidiaries
      of the Registrant23
              
              Consent
      of Turlington and Company, LLP31.1
              
              Rule
      13a-14(a) Certification of Chief Executive Officer31.2
              
              Rule
      13a-14(a) Certification of Chief Financial Officer32
              
              Certification
      pursuant to 18 U.S.C. Section
1350


___________________________


*     Management
contract or compensatory plan or arrangement.


40





(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.


41


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
      10 , 2009By:
              /s/ Thomas A. VannThomas
      A. VannPresident


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





/s/ Thomas A. Vann
              
              March
      10, 2009Thomas
      A. VannPresident
      and Director(Principal
      Executive Officer)/s/ William L. Wall
              
              March
      10, 2009William
      L. WallExecutive
      Vice President, Chief FinancialOfficer
      and Secretary(Principal
      Financial and Accounting Officer)/s/ Linley H. Gibbs, Jr.
              
              March
      10, 2009Linley
      H. Gibbs, Jr.Director/s/ Frederick N. Holscher
              
              March
      10, 2009Frederick
      N. HolscherDirector/s/ Frederick H. Howdy
              
              March
      10, 2009Frederick
      H. HowdyDirector/s/ Charles E. Parker, Jr.
              
              March
      10, 2009Charles
      E. Parker, Jr.Director/s/ Marshall T. Singleton
              
              March
      10, 2009Marshall
      T. SingletonDirector/s/ H. D. Reaves, Jr.
              
              March
      10, 2009H.
      D. Reaves, Jr.Director