2007
      Annual Report





*F* *irst* *S* *outh* *B* *ancorp*










**TABLE
        OF CONTENTS**
 
 Letter
                  to Stockholders
              2Selected
                  Consolidated Financial Information and Other Data
              4Management's
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              5Report
                  of Independent Registered Public Accounting Firm
              16Consolidated
                  Statements of Financial Condition
              17Consolidated
                  Statements of Operations
              18Consolidated
                  Statements of Changes in Stockholders' Equity
              19Consolidated
                  Statements of Cash Flows
              20Notes
                  to Consolidated Financial Statements
              21Board
                  of Directors
              42Executive
                  Officers
              42Area
                  Executives & Subsidiary Executives
              42City
                  & Branch Executives
              42First
                  South Bank Office Locations
              43Stockholder
                  Information
              44Comparative
                  Stock Performance Graph
              45
  **MISSION
        STATEMENT**
 
 "Our
        mission is to become the premier community bank in eastern North Carolina.
        We
        will enhance shareholder value by serving the personal and business needs
        of our
        markets, providing superior customer service, investing in the communities
        that
        we serve, and enriching the lives of our employees."
  
  **LETTER
        TO STOCKHOLDERS**
 
 To
        Our
        Stockholders:
 
 I
        am
        pleased to report the financial performance achieved by First South Bancorp
        (“First South”) and its wholly owned subsidiary, First South Bank (“Bank”)
        during the year ended December 31, 2007.
 
 For
        2007,
        First South earned net income of $17.0 million compared to net income of
        $17.2
        million earned in 2006. Diluted earnings per share were $1.70 per share for
        2007
        versus $1.72 per share for 2006. The significance of these earnings has been
        the
        Bank’s success of managing the interest sensitivity gap relationship between the
        maturity and repricing of its interest-earning assets and interest-bearing
        liabilities, during one of the most volatile periods in the banking sector’s
        history. This has allowed us to sustain the volume of our net interest income
        during a period of declining interest rates, slower loan growth, and competitive
        pressure on deposit flows in the market areas we serve.
 
 Although
        we are pleased with our 2007 operating performance, we do anticipate some
        volatility into 2008, which will continue to challenge our interest rate
        risk
        and asset/liability management strategies. The economy will be challenged
        in
        2008 with the housing slow down, rising energy costs, continued unrest in
        the
        Middle East, the election of new government leaders and uncertainty of further
        Federal Reserve interest rate cuts, as they are forecasting slow economic
        growth.
 
 At
        December 31, 2007, our total assets were $909.3 million; net loans and leases
        $765.1 million; cash and investments $115.4 million; deposits $761.4 million;
        borrowings $42.1 million; and stockholders’ equity $86.0 million. During 2007
        and amid intense competition on interest rates, the Bank repriced certain
        new
        and maturing time deposits at competitive market rates and also replaced
        certain
        maturing higher costing time deposits with lower costing FHLB borrowings,
        providing an effective means of managing our overall cost of funds.
 
 We
        also
        continued placing efforts on controlling operating expenses, resulting in
        a
        45.0% efficiency ratio for 2007. In addition, our key performance ratios,
        return
        on average assets (ROA) and return on average equity (ROE), continue to place
        us
        at the top of our peer group both on the national and statewide level. Our
        ROA
        and ROE were 1.9% and 20.3%, respectively, for 2007.
 
 During
        2007, the Board of Directors increased the quarterly cash dividend payment
        rate
        by 11.8%, and when combined with declaring four quarterly cash dividends
        totaling $0.76 per share, resulted in a dividend payout ratio on basic earnings
        to our shareholders of 44.4%.
 
 We
        enjoyed many positive events during 2007. We received national and statewide
        recognition for our operating efficiency and various operating performance
        ratios including return on average equity, 3-year return on average equity,
        5-year return on average equity and total market value from American
        Banker , ABA
        Banking Journal , U.
        S.
        Banker ,
        and the Charlotte
        Business Journal .
 
 First
        South was listed in the NASDAQ Global Select Market, which places us in a
        peer
        group of the top listed companies in the world. In addition, we retained
        our
        listing in the Russell Index of funds, which helps raise First South’s
        visibility with investors that rely on the Russell Indexes as part of their
        investment strategy. We are pleased with these recognitions, as they further
        exemplify the market awareness of First South and the Bank among both the
        business and investment communities.
 
 During
        2007, the Bank opened new full service branch offices in Greenville and
        Grantsboro, North Carolina; renovated full service branch offices in Durham
        and
        Fayetteville, North Carolina; and opened new loan production offices in Dunn
        and
        Wilmington, North Carolina.  During
        the first half of 2008, we will convert our Dunn, North Carolina loan production
        office to a full service banking facility, and will open a new loan production
        office in Durham, North Carolina. This expansion will allow us to better
        serve
        the banking needs in our growing market area, expand our customer base in
        existing markets and represents a continuation of the growth of our branch
        office network. In addition, the Bank has expanded the securities brokerage
        services we offer through an affiliation with a broker/dealer and now have
        full-time investment consultants located in Washington, Rocky Mount and
        Fayetteville, North Carolina, providing our customers access to investment
        management services.
  2
 
 First
        South Leasing, LLC, a wholly owned subsidiary of the Bank, continued its
        growth
        and expansion during 2007 by offering a variety of general equipment leases
        to
        the commercial markets in North Carolina and parts of South Carolina and
        Virginia. At December 31, 2007, the lease receivable portfolio was $13.1
        million.
 
 At
        this
        point, it is very difficult to predict the economic environment for 2008.
        At
        best, it will be challenging. We are hopeful the economy will not enter a
        recession and the problems created by the subprime mortgage market will be
        contained and resolved shortly. We will continue to review the mix of the
        assets
        and liabilities of the Bank and the products and services we offer in order
        to
        meet the challenges of a competitive world. While I believe our primary focus
        during 2008 will be internal, we will also explore opportunities for external
        growth.
 
 As
        stated
        in our Mission Statement, “Our mission is to become the premier community bank
        in eastern North Carolina.” This will continue to be our focus in 2008 as we
        grow our franchise. We are committed to building a high performance bank
        which
        provides superior returns to its shareholders, exemplary service to its
        customers and rewarding work for its employees.
 
 The
        financial results we achieved this year would not have been possible without
        the
        superior performance and dedication of our professional staff. We are
        appreciative of the quality of their work and proud of their many
        accomplishments. They are committed to First South, its principles and to
        providing their customers the highest possible standards of service. We will
        continue to invest in our employees, which will ultimately result in improved
        service to our customers and enhanced shareholder value.
 
 Each
        member of your Board of Directors along with our officers and employees join
        me
        in thanking you for supporting First South Bancorp. As always, we welcome
        your
        comments or suggestions and we look forward to your continued
        support.
  Sincerely,/s/
                  Tom VannTom
                  VannPresident
                  andChief
                  Executive Officer
  3
  **SELECTED
            CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA**
 
 At or For the Years Ended December 31, 2007, 2006,
                    2005, 2004 and 200312/31/07
                  
                  12/31/06
                  
                  12/31/05
                  
                  12/31/04
                  
                  12/31/03(dollars in thousands, except per share data)Selected
                      Financial Condition DataTotal
                      assets
                  
                  $
                  909,288
                  
                  $
                  910,548
                  
                  $
                  834,234
                  
                  $
                  722,051
                  
                  $
                  675,836Loans
                      receivable, net
                  
                  
                  765,083
                  
                  
                  761,437
                  
                  
                  708,929
                  
                  
                  631,816
                  
                  
                  553,200Cash
                      and investment securities
                  
                  
                  73,094
                  
                  
                  82,258
                  
                  
                  74,771
                  
                  
                  52,997
                  
                  
                  84,996Mortgage-backed
                      securities
                  
                  
                  39,120
                  
                  
                  36,729
                  
                  
                  22,702
                  
                  
                  9,209
                  
                  
                  11,715Deposits
                  
                  
                  761,370
                  
                  
                  800,188
                  
                  
                  733,753
                  
                  
                  628,537
                  
                  
                  583,173Borrowings
                  
                  
                  52,377
                  
                  
                  21,450
                  
                  
                  22,098
                  
                  
                  25,102
                  
                  
                  29,648Stockholders'
                      equity
                  
                  
                  86,035
                  
                  
                  78,797
                  
                  
                  68,190
                  
                  
                  59,695
                  
                  
                  55,164Selected
                      Operations DataInterest
                      income
                  
                  $
                  70,078
                  
                  $
                  67,752
                  
                  $
                  53,176
                  
                  $
                  40,180
                  
                  $
                  36,905Interest
                      expense
                  
                  
                  29,111
                  
                  
                  25,607
                  
                  
                  15,464
                  
                  
                  9,692
                  
                  
                  10,186Net
                      interest income
                  
                  
                  40,967
                  
                  
                  42,145
                  
                  
                  37,712
                  
                  
                  30,488
                  
                  
                  26,719Provision
                      for credit losses
                  
                  
                  350
                  
                  
                  933
                  
                  
                  1,711
                  
                  
                  968
                  
                  
                  988Noninterest
                      income
                  
                  
                  10,137
                  
                  
                  9,259
                  
                  
                  8,207
                  
                  
                  8,750
                  
                  
                  10,502Noninterest
                      expenses
                  
                  
                  22,911
                  
                  
                  22,207
                  
                  
                  21,132
                  
                  
                  19,592
                  
                  
                  17,979Income
                      before income taxes
                  
                  
                  27,843
                  
                  
                  28,264
                  
                  
                  23,076
                  
                  
                  18,678
                  
                  
                  18,254Income
                      taxes
                  
                  
                  10,840
                  
                  
                  11,072
                  
                  
                  8,947
                  
                  
                  6,966
                  
                  
                  6,841Net
                      income
                  
                  $
                  17,003
                  
                  $
                  17,192
                  
                  $
                  14,129
                  
                  $
                  11,712
                  
                  $
                  11,413Per
                      Share DataEarnings
                      per share - basic(1)
                  
                  $
                  1.71
                  
                  $
                  1.77
                  
                  $
                  1.49
                  
                  $
                  1.25
                  
                  $
                  1.22Earnings
                      per share - diluted(1)
                  
                  
                  1.70
                  
                  
                  1.72
                  
                  
                  1.41
                  
                  
                  1.19
                  
                  
                  1.15Dividends
                      per share(1)
                  
                  
                  0.76
                  
                  
                  0.68
                  
                  
                  0.53
                  
                  
                  0.45
                  
                  
                  0.35Selected
                      Financial Ratios and Other DataPerformance
                      Ratios:Return
                      on average assets
                  
                  
                  1.87
                  %
                  
                  1.93
                  %
                  
                  1.78
                  %
                  
                  1.64
                  %
                  
                  1.76
                  %Return
                      on average equity
                  
                  
                  20.34
                  
                  
                  23.45
                  
                  
                  21.92
                  
                  
                  20.50
                  
                  
                  22.06Interest
                      rate spread
                  
                  
                  4.63
                  
                  
                  4.94
                  
                  
                  5.04
                  
                  
                  4.63
                  
                  
                  4.46Net
                      interest margin
                  
                  
                  4.80
                  
                  
                  5.05
                  
                  
                  5.11
                  
                  
                  4.66
                  
                  
                  4.49Average
                      earning assets/averageinterest
                      bearing liabilities
                  
                  
                  120.41
                  
                  
                  119.20
                  
                  
                  118.66
                  
                  
                  116.63
                  
                  
                  114.16Noninterest
                      expense/average assets
                  
                  
                  2.53
                  
                  
                  2.50
                  
                  
                  2.67
                  
                  
                  2.75
                  
                  
                  2.77Efficiency
                      ratio
                  
                  
                  44.99
                  
                  
                  43.14
                  
                  
                  45.95
                  
                  
                  49.87
                  
                  
                  48.30Dividend
                      payout ratio
                  
                  
                  44.44
                  
                  
                  38.42
                  
                  
                  35.87
                  
                  
                  36.36
                  
                  
                  29.09Quality
                      Ratios:Nonperforming
                      assets/total assets
                  
                  
                  1.01
                  %
                  
                  0.37
                  %
                  
                  0.27
                  %
                  
                  0.34
                  %
                  
                  0.41
                  %Nonperforming
                      loans/total loans
                  
                  
                  0.99
                  
                  
                  0.36
                  
                  
                  0.32
                  
                  
                  0.37
                  
                  
                  0.47Allowance
                      for credit losses/total loans
                  
                  
                  1.27
                  
                  
                  1.29
                  
                  
                  1.29
                  
                  
                  1.30
                  
                  
                  1.36Provision
                      for credit losses/total loans
                  
                  
                  0.05
                  
                  
                  0.12
                  
                  
                  0.24
                  
                  
                  0.15
                  
                  
                  0.18Capital
                      Ratios and Other Data:Equity/total
                      assets, end of period
                  
                  
                  9.46
                  %
                  
                  8.65
                  %
                  
                  8.18
                  %
                  
                  8.28
                  %
                  
                  8.16
                  %Average
                      equity/average assets
                  
                  
                  9.21
                  
                  
                  8.24
                  
                  
                  8.13
                  
                  
                  8.02
                  
                  
                  7.96Full
                      service offices
                  
                  
                  29
                  
                  
                  26
                  
                  
                  26
                  
                  
                  25
                  
                  
                  22Loans
                      serviced for others
                  
                  $
                  254,671
                  
                  $
                  245,633
                  
                  $
                  260,632
                  
                  $
                  277,252
                  
                  $
                  288,917
  (1)
            Adjusted for three-for-two stock splits on May 25, 2006 and April 23,
            2004.
  4
  **MANAGEMENT'S
        DISCUSSION AND ANALYSIS**
 **OF
        FINANCIAL CONDITION AND RESULTS OF OPERATIONS**
  **General** **.** First
        South Bancorp, Inc. (the "Company") was formed to issue common stock, owning
        100% of First South Bank (the "Bank") and operating through the Bank a
        commercial banking business; therefore, this discussion of consolidated
        financial condition and results of operations relates principally to the
        Bank.
        The business of the Bank consists principally of attracting deposits from
        the
        general public and using them to originate secured and unsecured commercial
        and
        consumer loans, permanent mortgage and construction loans secured by
        single-family residences and other loans. The Bank's earnings depend primarily
        on its net interest income, the difference between interest earned on interest
        earning assets and interest paid on interest-bearing liabilities. The volume
        of
        noninterest income and expenses also affects the Bank’s earnings.
 
 Prevailing
        economic conditions, as well as federal and state regulations, affect the
        operations of the Bank. The Bank's cost of funds is influenced by interest
        rates
        paid on competing investments, rates offered on deposits by other financial
        institutions in the Bank's market area and by general market interest rates.
        Lending activities are affected by the demand for financing of real estate
        and
        various types of commercial and consumer loans, and by interest rates at
        which
        such financing are offered. The Bank's business emphasis is to operate as
        a
        well-capitalized, profitable and independent community oriented financial
        institution dedicated to providing quality customer service and meeting the
        financial needs of the communities it serves. Management believes the Bank
        can
        be more effective in serving its customers than many larger competitors because
        of its ability to respond quickly and effectively to customer needs and
        inquiries. The Bank's ability to provide these services is enhanced by the
        stability of the Bank's senior management team.
 
 The
        Company's common stock is listed and trades on the NASDAQ Global Select Market
        under the symbol FSBK.
 
 **Stock
        Split** **.** On
        May
        25, 2006 the Company paid a three-for-two stock split, in the form of a 50%
        stock dividend, to stockholders of record as of May 4, 2006. Stockholders
        received one additional share of common stock for every two shares held on
        the
        record date. All prior period share and per share data have been adjusted
        for
        the split.
 
 **Liquidity
        and Capital Resources** **.** The
        Bank's primary sources of funds are deposits, principal and interest payments
        on
        loans, proceeds from loan and securities sales, and advances from the Federal
        Home Loan Bank of Atlanta (the "FHLB"). While maturities and scheduled
        amortization of loans are predictable sources of funds, deposit flows and
        loan
        prepayments are influenced by interest rates, economic conditions and local
        competition. The Bank’s primary investing activity is the origination of
        commercial, consumer and mortgage loans and lease financing receivables.
        The
        Bank’s primary financing activities are the attraction of checking, certificate
        and savings deposits, and obtaining FHLB advances.
 
 The
        levels of cash and cash equivalents depend on the Bank's operating, financing,
        lending and investing activities during any given period. At December 31,
        2007
        and 2006, cash and cash equivalents totaled $24.0 million and $25.8 million,
        respectively. The Bank has other sources of liquidity if a need for additional
        funds arises. Investment and mortgage-backed securities available for sale
        totaled $86.9 million at December 31, 2007 and $91.5 million at December
        31,
        2006. During the years ended December 31, 2007 and 2006, the Bank sold or
        exchanged real estate loans of $42.2 million and $18.4 million, respectively.
        Borrowings consisting of FHLB advances, junior subordinated debentures and
        retail repurchase agreements were $52.4 million at December 31, 2007 compared
        to
        $21.4 million at December 31, 2006. The Bank has pledged its FHLB Atlanta
        stock
        and certain loans as collateral for actual or potential FHLB advances. The
        Bank
        has a minimum credit availability with the FHLB of 40% of the Bank’s total
        assets. At December 31, 2007 the Bank had unused credit availability with
        the
        FHLB of $328.7 million, compared to $357.3 million at December 31,
        2006.
 
 The
        Company had $10.3 million of junior subordinated debentures at December 31,
        2007
        and 2006, respectively, issued through a private placement pooled trust
        preferred securities offering by First South Preferred Trust I, a Delaware
        statutory trust. The trust preferred securities bear interest at a rate of
        2.95%
        over three-month LIBOR payable quarterly, have a 30-year maturity and are
        first
        redeemable, in whole or in part, on or after September 30, 2008, with certain
        exceptions. For regulatory purposes, the $10.3 million total of trust preferred
        securities qualifies as Tier 1 capital for the Company and the Bank, to the
        extent such proceeds have been invested in the Bank and the Company. Proceeds
        from the trust preferred securities were used by the statutory trust to purchase
        junior subordinated debentures issued by the Company. For additional
        information, see Note 19 of Notes to Consolidated Financial
        Statements.
  5
  As
        a
        North Carolina chartered commercial bank and a Federal Deposit Insurance
        Corporation (the "FDIC") insured institution, the Bank is required to meet
        various state and federal regulatory capital standards. The Bank's stand-alone
        equity was $85.5 million at December 31, 2007, compared to $81.1 million
        at
        December 31, 2006. The Commissioner requires the Bank to maintain a capital
        surplus of not less than 50% of common capital stock. The FDIC requires the
        Bank
        to meet a minimum leverage capital requirement of Tier I capital (consisting
        of
        retained earnings and common stockholders' equity, less any intangible assets)
        to assets ratio of at least 4%, and a total capital to risk-weighted assets
        ratio of 8%, of which 4% must be in the form of Tier I capital. The Bank
        was in
        compliance with all regulatory capital requirements at December 31, 2007
        and
        2006.
  At
        December 31, 2007, stockholders' equity was $86.0 million, compared to $78.8
        million at December 31, 2006. Net income for fiscal 2007 was $17.0 million,
        compared to $17.2 million for fiscal 2006. At December 31, 2007, there were
        9,808,655 shares of common stock outstanding, net of 1,445,567 treasury shares.
  **Contractual
        Obligations and Commitments** **.** In
        the
        normal course of business there are various outstanding contractual obligations
        of the Company that will require future cash outflows. In addition, there
        are
        commitments and contingent liabilities, such as commitments to extend credit,
        which may or may not require future cash outflows. Table 1 below reflects
        contractual obligations of the Company outstanding as of December 31, 2007.
 
 **Table
        1 – Contractual Obligations and Commitments**
 Payments
                    Due by PeriodContractual
                    Obligations
                
                Total
                
                Less Than
                  1Year
                
                1-3 Years
                
                4-5 Years
                
                Over
                  5 Years(In
                    thousands)Borrowed
                    money
                
                $
                42,067
                
                $
                35,000
                
                $
                7,067
                
                $
                -
                
                $
                -Junior
                    subordinated debentures
                
                
                10,310
                
                
                -
                
                
                -
                
                
                -
                
                
                10,310Lease
                    obligations
                
                
                1,173
                
                
                537
                
                
                499
                
                
                137
                
                
                -Deposits
                
                
                761,370
                
                
                745,653
                
                
                12,533
                
                
                3,184
                
                
                -Total
                    contractual cash obligations
                
                $
                814,920
                
                $
                781,190
                
                $
                20,099
                
                $
                3,321
                
                $
                10,310
 
 
 Amount
                    of Commitment Expiration Per PeriodOther
                    Commitments
                
                Total
                  Amounts
                  Committed
                
                Less than
                  1
                    Year
                
                1-3 Years
                
                4-5 Years
                
                Over
                  5 Years(In
                    thousands)Commitments
                    to originate loans
                
                $
                122,786
                
                $
                104,211
                
                $
                18,575
                
                $
                -
                
                $
                -Undrawn
                    balances on lines of credit and undrawn balances on credit
                    reserves
                
                
                53,565
                
                
                1,591
                
                
                2,339
                
                
                4,953
                
                
                44,682Standby
                    letters of credit
                
                
                1,416
                
                
                1,416
                
                
                -
                
                
                -
                
                
                -Total
                    other commitments
                
                $
                177,767
                
                $
                107,218
                
                $
                20,914
                
                $
                4,953
                
                $
                44,682
 
 In
        the
        normal course of business, the Company may enter into purchase agreements
        for
        goods or services. In management’s opinion, the dollar amount of such agreements
        at December 31, 2007 is not material and has not been included in Table 1
        above.
 
 **Asset/Liability
        Management** **.** The
        Bank
        strives to maintain consistent net interest income and reduce its exposure
        to
        adverse changes in interest rates by matching the terms to repricing of its
        interest-sensitive assets and liabilities. Factors beyond the Bank's control,
        such as market interest rates and competition, may also impact interest income
        and interest expense. The Bank's net interest income will generally increase
        when interest rates rise over an extended period of time, and conversely,
        will
        decrease when interest rates decline. The Bank can significantly influence
        its
        net interest income by controlling the increases and decreases in its interest
        income and interest expense, which are primarily caused by changes in market
        interest rates. See Table 2 below for additional information on the effects
        of
        net interest income caused by changes in interest rates.
  6
  Interest
        rate risk and trends, liquidity and capital ratio requirements are reported
        to
        the Board on a regular basis. The Board reviews the maturities of the Bank's
        assets and liabilities and establishes policies and strategies designed to
        regulate the flow of funds and to coordinate the sources, uses and pricing
        of
        such funds. The first priority in structuring and pricing assets and liabilities
        is to maintain an acceptable interest rate spread while reducing the net
        effects
        of changes in interest rates. The Bank's management is responsible for
        administering the policies and determinations of the Board with respect to
        the
        Bank's asset and liability goals and strategies.
  A
        primary
        approach in managing the Bank's interest rate risk has been to increase interest
        sensitive assets such as commercial loans, consumer loans and lease financing
        receivables. At December 31, 2007, the Bank had $724.8 million of commercial
        loans, consumer loans and lease receivables, compared to $697.3 million at
        December 31, 2006. The Bank had $7.5 million of loans held for sale at December
        31, 2007, compared to $25.6 million at December 31, 2006. Depending on
        conditions existing at a given time, the Bank may sell fixed-rate residential
        mortgage loans in the secondary market. In managing its portfolio of investment
        securities, a majority of investment and mortgage-backed securities are held
        as
        available for sale, allowing the Bank to sell a security in a timely manner
        should an immediate liquidity need arise. The Bank had $86.9 million of
        investment and mortgage-backed securities classified as available for sale
        at
        December 31, 2007, compared to $91.5 million at December 31, 2006.
 
 **Market
        Risk** **.** Market
        risk reflects the risk of economic loss resulting from changes in market
        prices
        and interest rates. The risk of loss can be reflected in diminished current
        market values and/or reduced potential net interest income in future periods.
        Market risk arises primarily from interest rate risk inherent in lending
        and
        deposit taking activities. The Bank does not maintain a trading account for
        any
        class of financial instruments, nor does it engage in hedging activities
        or
        purchase high-risk derivative instruments. Furthermore, the Bank is not subject
        to foreign currency exchange risk or commodity price risk.
 
 The
        Bank
        measures interest rate risk by computing estimated changes in net interest
        income and the net portfolio value ("NPV") of its cash flows from assets,
        liabilities and off-balance sheet items in the event of a range of assumed
        changes in market interest rates. The Bank's exposure to interest rates is
        reviewed on a quarterly basis by management and the Board. Exposure to interest
        rate risk is measured with the use of interest rate sensitivity analysis
        to
        determine the change in NPV in the event of hypothetical changes in interest
        rates, while interest rate sensitivity gap analysis is used to determine
        the
        repricing characteristics of assets and liabilities. If estimated changes
        to NPV
        and net interest income are not within the limits established by the Board,
        it
        may direct management to adjust the Bank's asset and liability mix to bring
        interest rate risk within Board approved limits.
 
 NPV
        represents the market value of portfolio equity and is equal to the market
        value
        of assets minus the market value of liabilities, with adjustments made for
        off-balance sheet items. This analysis assesses the potential loss in risk
        sensitive instruments in the event of sudden and sustained 1% to 3% increases
        and decreases in market interest rates. The Board has adopted an interest
        rate
        risk policy that establishes maximum increases in NPV of 19%, 39% and 60%
        and
        decreases in NPV of 19%, 37% and 54% in the event of sudden and sustained
        1% to
        3% increases or decreases in market interest rates. Table 2 below presents
        the
        Bank's projected changes in NPV and net interest income in the event of sudden
        and sustained increases or decreases in market interest rates for the various
        rate shock levels at December 31, 2007. At December 31, 2007, the Bank's
        estimated changes in NPV and net interest income were within the targets
        established by the Board.
 
 **Table
        2 - Projected Change in NPV and Net Interest Income**
  Change
              
              
              
              Net
                  Portfolio Value
              
              Net
                  Interest Incomein Rates
              
              
              
              $
                  Amount
              
              $
                  Change
              
              %
                  Change
              
              $
                  Amount
              
              $
                  Change
              
              %
                  Change(Dollars
                  in thousands)+
                  300
              
              
              bp
              
              $
              109,116
              
              $
              (7,149
              )
              
              (6.1
              )%
              $
              31,755
              
              $
              2,020
              
              
              6.8
              %+
                  200
              
              
              bp
              
              
              113,024
              
              
              (3,241
              )
              
              (2.8
              )
              
              31,103
              
              
              1,368
              
              
              4.6+
                  100
              
              
              bp
              
              
              115,239
              
              
              (1,026
              )
              
              (0.9
              )
              
              30,466
              
              
              731
              
              
              2.5Base
              
              
              
              
              
              116,265
              
              
              —
              
              
              —
              
              
              29,735
              
              
              —
              
              
              —-
                  100
              
              
              bp
              
              
              116,974
              
              
              709
              
              
              0.6
              
              
              28,928
              
              
              (807
              )
              
              (2.7
              )-
                  200
              
              
              bp
              
              
              115,525
              
              
              (740
              )
              
              (0.6
              )
              
              27,904
              
              
              (1,831
              )
              
              (6.2
              )-
                  300
              
              
              bp
              
              
              113,618
              
              
              (2,647
              )
              
              (2.3
              )
              
              26,574
              
              
              (3,161
              )
              
              (10.6
              )
  7
  The
        NPV
        calculation is based on the net present value of discounted cash flows utilizing
        market prepayment assumptions. Computations
        of prospective effects of hypothetical interest rate changes are based on
        numerous assumptions, including relative levels of market interest rates,
        loan
        prepayments and deposit decay rates, and should not be relied upon as indicative
        of actual results. Further, the computations do not contemplate any actions
        the
        Bank may undertake in response to changes in interest rates.
  Certain
        shortcomings are inherent in the method of analysis presented in Table 2.
        For
        example, although certain assets and liabilities may have similar maturities
        to
        repricing, they may react in differing degrees to changes in market interest
        rates. The interest rates on certain types of assets and liabilities may
        fluctuate in advance of changes in market interest rates, while interest
        rates
        on other types may lag behind changes in market rates. Certain assets, such
        as
        adjustable-rate loans, have features that restrict changes in interest rates
        on
        a short-term basis and over the life of the asset. In addition, the proportion
        of adjustable-rate loans in the Bank's portfolio could decrease in future
        periods if market interest rates remain at or decrease below current levels
        due
        to refinance activity. Further, in the event of a change in interest rates,
        prepayment and early withdrawal levels would likely deviate from those assumed
        in the table. Also, the ability of many borrowers to repay their adjustable-rate
        debt may decrease in the event of an increase in interest rates.
 
 In
        addition, the Bank uses interest sensitivity gap analysis to monitor the
        relationship between the maturity and repricing of its interest-earning assets
        and interest-bearing liabilities, while maintaining an acceptable interest
        rate
        spread. Interest sensitivity gap is defined as the difference between the
        amount
        of interest-earning assets maturing or repricing within a specific time period
        and the amount of interest-bearing liabilities maturing or repricing within
        that
        time period. A gap is considered positive when the amount of interest-sensitive
        assets exceeds the amount of interest-sensitive liabilities, and is considered
        negative when the amount of interest-sensitive liabilities exceeds the amount
        of
        interest-sensitive assets. Generally, during a period of rising interest
        rates,
        a negative gap would adversely affect net interest income, while a positive
        gap
        would result in an increase in net interest income. Conversely, during a
        period
        of falling interest rates, a negative gap would result in an increase in
        net
        interest income, while a positive gap would negatively affect net interest
        income. The Bank's goal is to maintain a reasonable balance between exposure
        to
        interest rate fluctuations and earnings.
 
 **Rate/Volume
        Analysis** .
        Net
        interest income can also be analyzed in terms of the impact of changing interest
        rates on average interest-earning assets and average interest-bearing
        liabilities, and the changing volume or amount of these assets and liabilities.
 
 Table
        3
        below represents the extent to which changes in interest rates and changes
        in
        the volume of average interest-earning assets and average interest-bearing
        liabilities have affected the Company's interest income and interest expense
        during the periods indicated. For each category of average interest-earning
        asset and average interest-bearing liability, information is provided on
        changes
        attributable to: (i) changes in volume (changes in volume multiplied by old
        rate); (ii) changes in rate (change in rate multiplied by old volume); (iii)
        changes in rate-volume (changes in rate multiplied by the changes in volume);
        and (iv) net change (total of the previous columns).
 
 **Analysis
        of Net Interest Income** **.** Net
        interest income primarily represents the difference between income derived
        from
        interest-earning assets and interest expense on interest-bearing liabilities.
        Net interest income is affected by both the difference between the yield
        on
        earning assets and the average cost of funds ("interest rate spread"), and
        the
        relative volume of interest-earning assets, interest-bearing liabilities
        and
        noninterest-bearing deposits.
 
 Table
        4
        below sets forth certain information relating to the Company's Statements
        of
        Financial Condition and Statements of Operations for the three years ended
        December 31, 2007, 2006, and 2005, reflecting the yield on average earning
        assets and the average cost of funds for the periods indicated. Average balances
        are derived from month end balances. The Company does not believe that using
        month end balances rather than average daily balances has caused any material
        difference in the information presented.
  8
  **Table
                      3 - Rate/Volume
                      Analysis**
  Year
                    Ended December 31,
                
                Year
                    Ended December 31,2007
                    vs. 2006
                
                2006
                    vs. 2005Increase
                    (Decrease) Due to
                
                Increase
                    (Decrease) Due to(In
                    thousands)Rate/
                
                
                
                
                
                
                
                Rate/Volume
                
                Rate
                
                Volume
                
                Total
                
                Volume
                
                Rate
                
                Volume
                
                TotalInterest
                    income:Loans
                    receivable
                
                $
                609
                
                $
                1,157
                
                $
                11
                
                $
                1,777
                
                $
                4,544
                
                $
                7,610
                
                $
                687
                
                $
                12,841Investment
                    securities
                
                
                (51
                )
                
                (213
                )
                
                4
                
                
                (260
                )
                
                978
                
                
                (221
                )
                
                (111
                )
                
                646Mortgage-backed
                    securities
                
                
                343
                
                
                (8
                )
                
                (2
                )
                
                333
                
                
                1,181
                
                
                11
                
                
                25
                
                
                1,217Other
                    interest-earning assets
                
                
                452
                
                
                8
                
                
                16
                
                
                476
                
                
                (202
                )
                
                170
                
                
                (96
                )
                
                (128
                )Total
                    earning assets
                
                
                1,353
                
                
                944
                
                
                29
                
                
                2,326
                
                
                6,501
                
                
                7,570
                
                
                505
                
                
                14,576Interest
                    expense:Deposits
                
                
                446
                
                
                3,137
                
                
                58
                
                
                3,641
                
                
                1,657
                
                
                6,877
                
                
                783
                
                
                9,317FHLB
                    advances
                
                
                (162
                )
                
                (27
                )
                
                7
                
                
                (182
                )
                
                192
                
                
                127
                
                
                201
                
                
                520Other
                    interest-bearing liabilities
                
                
                4
                
                
                41
                
                
                0
                
                
                45
                
                
                28
                
                
                270
                
                
                9
                
                
                307Total
                    interest-bearing liabilities
                
                
                288
                
                
                3,151
                
                
                65
                
                
                3,504
                
                
                1,877
                
                
                7,274
                
                
                993
                
                
                10,144Change
                    in net interest income
                
                $
                1,065
                
                $
                (2,207
                )
                $
                (36
                )
                $
                (1,178
                )
                $
                4,624
                
                $
                296
                
                $
                (488
                )
                $
                4,432
  Year
                      Ended December 31,
                  
                  Year
                      Ended December 31,2005
                      vs. 2004
                  
                  2004
                      vs. 2003Increase
                      (Decrease) Due to
                  
                  Increase
                      (Decrease) Due to(In
                      thousands)Rate/
                  
                  
                  
                  
                  
                  
                  
                  Rate/Volume
                  
                  Rate
                  
                  Volume
                  
                  Total
                  
                  Volume
                  
                  Rate
                  
                  Volume
                  
                  TotalInterest
                      income:Loans
                      receivable
                  
                  $
                  5,483
                  
                  $
                  7,067
                  
                  $
                  1,055
                  
                  $
                  13,605
                  
                  $
                  4,853
                  
                  $
                  (430
                  )
                  $
                  (65
                  )
                  $
                  4,358Investment
                      securities
                  
                  
                  (535
                  )
                  
                  (349
                  )
                  
                  67
                  
                  
                  (817
                  )
                  
                  (649
                  )
                  
                  123
                  
                  
                  (24
                  )
                  
                  (550
                  )Mortgage-backed
                      securities
                  
                  
                  (36
                  )
                  
                  (23
                  )
                  
                  2
                  
                  
                  (57
                  )
                  
                  (478
                  )
                  
                  (47
                  )
                  
                  21
                  
                  
                  (504
                  )Other
                      interest-earning assets
                  
                  
                  108
                  
                  
                  72
                  
                  
                  85
                  
                  
                  265
                  
                  
                  (34
                  )
                  
                  7
                  
                  
                  (2
                  )
                  
                  (29
                  )Total
                      earning assets
                  
                  
                  5,020
                  
                  
                  6,767
                  
                  
                  1,209
                  
                  
                  12,996
                  
                  
                  3,692
                  
                  
                  (347
                  )
                  
                  (70
                  )
                  
                  3,275Interest
                      expense:Deposits
                  
                  
                  1,233
                  
                  
                  3,840
                  
                  
                  530
                  
                  
                  5,603
                  
                  
                  477
                  
                  
                  (1,433
                  )
                  
                  (69
                  )
                  
                  (1,025
                  )FHLB
                      advances
                  
                  
                  (184
                  )
                  
                  133
                  
                  
                  (93
                  )
                  
                  (144
                  )
                  
                  62
                  
                  
                  68
                  
                  
                  49
                  
                  
                  179Other
                      interest-bearing liabilities
                  
                  
                  63
                  
                  
                  221
                  
                  
                  28
                  
                  
                  312
                  
                  
                  118
                  
                  
                  125
                  
                  
                  109
                  
                  
                  352Total
                      interest-bearing liabilities
                  
                  
                  1,112
                  
                  
                  4,194
                  
                  
                  465
                  
                  
                  5,771
                  
                  
                  657
                  
                  
                  (1,240
                  )
                  
                  89
                  
                  
                  (494
                  )Change
                      in net interest income
                  
                  $
                  3,908
                  
                  $
                  2,573
                  
                  $
                  744
                  
                  $
                  7,225
                  
                  $
                  3,035
                  
                  $
                  893
                  
                  $
                  (159
                  )
                  $
                  3,769
  9
  **Table
          4 - Yield/Cost Analysis**
  Year Ended December 31,
                
                Year Ended December 31,
                
                Year Ended December 31,2007
                
                
                
                
                
                2006
                
                
                
                
                
                2005(In thousands)Average
                
                
                
                
                
                Average
                
                
                
                
                
                AverageAverage
                
                
                
                Yield/
                
                Average
                
                
                
                Yield/
                
                Average
                
                
                
                Yield/Balance
                
                Interest
                
                Cost
                
                Balance
                
                Interest
                
                Cost
                
                Balance
                
                Interest
                
                CostInterest
                    earning assets:Loans
                    receivable (1)
                
                $
                755,502
                
                $
                64,975
                
                
                8.60
                %
                $
                748,296
                
                $
                63,198
                
                
                8.45
                %
                $
                686,357
                
                $
                50,357
                
                
                7.34
                %Investment
                    securities
                
                
                50,891
                
                
                2,340
                
                
                4.60
                
                
                51,919
                
                
                2,600
                
                
                5.01
                
                
                34,596
                
                
                1,954
                
                
                5.65Mortgage-backed
                    securities
                
                
                37,097
                
                
                2,058
                
                
                5.55
                
                
                30,941
                
                
                1,725
                
                
                5.58
                
                
                9,303
                
                
                508
                
                
                5.46Other
                    interest-earning assets
                
                
                10,102
                
                
                705
                
                
                6.98
                
                
                3,397
                
                
                229
                
                
                6.74
                
                
                7,817
                
                
                357
                
                
                4.57Total
                    earning assets
                
                
                853,592
                
                
                70,078
                
                
                8.21
                
                
                834,553
                
                
                67,752
                
                
                8.12
                
                
                738,073
                
                
                53,176
                
                
                7.20Nonearning
                    assets
                
                
                53,741
                
                
                
                
                
                
                
                
                55,349
                
                
                
                
                
                
                
                
                53,826Total
                    assets
                
                $
                907,333
                
                
                
                
                
                
                
                $
                889,902
                
                
                
                
                
                
                
                $
                791,899Interest
                    bearing liabilities:Time
                    deposits
                
                $
                505,142
                
                
                24,343
                
                
                4.82
                
                $
                502,167
                
                
                21,674
                
                
                4.32
                
                $
                429,127
                
                
                13,247
                
                
                3.08Demand
                    deposits
                
                
                157,125
                
                
                3,129
                
                
                1.99
                
                
                145,206
                
                
                2,153
                
                
                1.48
                
                
                147,852
                
                
                1,260
                
                
                0.85Savings
                
                
                18,584
                
                
                28
                
                
                0.15
                
                
                20,993
                
                
                32
                
                
                0.15
                
                
                23,028
                
                
                35
                
                
                0.15FHLB
                    advances
                
                
                11,246
                
                
                459
                
                
                4.08
                
                
                15,035
                
                
                641
                
                
                4.26
                
                
                5,808
                
                
                121
                
                
                2.08Junior
                    subordinated debentures
                
                
                10,310
                
                
                839
                
                
                8.14
                
                
                10,310
                
                
                815
                
                
                7.90
                
                
                10,310
                
                
                633
                
                
                6.14Repurchase
                    agreements
                
                
                6,472
                
                
                313
                
                
                4.84
                
                
                6,417
                
                
                292
                
                
                4.55
                
                
                5,863
                
                
                167
                
                
                2.85Total
                    interest-bearing liabilities
                
                
                708,879
                
                
                29,111
                
                
                4.11
                
                
                700,128
                
                
                25,607
                
                
                3.66
                
                
                621,988
                
                
                15,463
                
                
                2.49Noninterest
                    bearing demand deposits
                
                
                103,571
                
                
                0
                
                
                0.00
                
                
                104,693
                
                
                0
                
                
                0.00
                
                
                94,719
                
                
                0
                
                
                0.00Total
                    sources of funds
                
                
                812,450
                
                
                29,111
                
                
                3.58
                
                
                804,821
                
                
                25,607
                
                
                3.18
                
                
                716,707
                
                
                15,463
                
                
                2.16Other
                    liabilities and stockholders'equity:Other
                    liabilities
                
                
                11,275
                
                
                
                
                
                
                
                
                11,751
                
                
                
                
                
                
                
                
                10,748Stockholders'
                    equity
                
                
                83,608
                
                
                
                
                
                
                
                
                73,330
                
                
                
                
                
                
                
                
                64,444Total
                    liabilities and stockholders' equity
                
                $
                907,333
                
                
                
                
                
                
                
                $
                889,902
                
                
                
                
                
                
                
                $
                791,899Net
                    interest income
                
                
                
                
                $
                40,967
                
                
                
                
                
                
                
                $
                42,145
                
                
                
                
                
                
                
                $
                37,713Interest
                    rate spread (2)
                
                
                
                
                
                
                
                
                4.63
                %
                
                
                
                
                
                
                
                4.94
                %
                
                
                
                
                
                
                
                5.04
                %Net
                    yield on earning assets (3)
                
                
                
                
                
                
                
                
                4.80
                %
                
                
                
                
                
                
                
                5.05
                %
                
                
                
                
                
                
                
                5.11
                %Ratio
                    of earning assets to interest bearing liabilities
                
                
                
                
                
                
                
                
                120.41
                %
                
                
                
                
                
                
                
                119.20
                %
                
                
                
                
                
                
                
                118.66
                %
  
 (1)  Includes
          classified loans
 (2)  Represents the difference between the yield on earning assets and the average
          cost of funds.
 (3)  Represents the net interest income divided by average earning
          assets.
  10
  **Results
        of Operations**
 
 ***Comparison
        of Financial Condition at December 31, 200*** **7
        *and 2006***
 
 Total
        assets were $909.3 million at December 31, 2007, compared to $910.5 million
        at
        December 31, 2006. Earning assets were $858.2 million at December 31, 2007,
        compared to $857.7 million at December 31, 2006, reflecting the net change
        in
        the growth and mix of loan and leases receivable and investment securities.
        Earning assets were 94.4% of total assets at December 31, 2007, compared
        to 94.2
        % at December 31, 2006.
 
 Loans
        and
        lease receivables, net of allowance for loan and lease losses and deferred
        loan
        fees, increased to $765.1 million at December 31, 2007 from $761.4 million
        at
        December 31, 2006. The Bank continues to emphasize the origination of both
        secured and unsecured commercial and consumer loans, in order to take advantage
        of shorter terms to maturity in managing its exposure to market and interest
        rate risk due to changes in interest rates. The Bank also sells selected
        mortgage loans in the secondary mortgage market in order to reduce its exposure
        to interest rate and credit risk, while retaining servicing to generate
        additional fee income. Loans serviced for others increased to $254.7 million
        at
        December 31, 2007 from $245.6 million serviced at December 31, 2006.
 
 Commercial
        loans and lease receivables increased to $623.1 million at December 31, 2007
        from $593.5 million at December 31, 2006, while consumer loans declined to
        $101.7 million at December 31, 2007 from $103.8 million at December 31, 2006,
        reflecting the Bank's continuing focus on the growth its commercial and consumer
        loan and lease receivables portfolio. Commercial and consumer loans and lease
        receivables originations were $315.8 million during fiscal 2007, compared
        to
        $359.9 million during fiscal 2006.
 
 Residential
        real estate mortgage loans declined to $51.2 million at December 31, 2007
        from
        $74.7 million at December 31, 2006, reflecting principal repayments, loan
        origination volume, loan sales and securitizations. During fiscal 2007, the
        Bank
        originated $52.3 million of residential mortgage loans, compared to $94.5
        million during fiscal 2006. The Bank sold $35.4 million of loans held for
        sale
        during fiscal 2007, compared to $1.2 million sold during fiscal 2006, reflecting
        the national housing slow down, slow economic growth and uncertainty of further
        Federal Reserve interest rate adjustments.
 
 Investment
        and mortgage-backed securities declined to $88.2 million at December 31,
        2007,
        from $93.2 million at December 31, 2006. During fiscal 2007, the Bank had
        $9.0
        million of maturities of investment securities available for sale, compared
        to
        $10.0 million of maturities in fiscal 2006. During fiscal 2007, the Bank
        purchased $500,000 of investment securities available for sale, compared
        to
        $25.0 million purchased in fiscal 2006. During fiscal 2007, the Bank securitized
        $6.9 million of mortgage loans held for sale into mortgage-backed securities,
        compared to $17.2 million securitized during fiscal 2006, in order to support
        future liquidity management needs.  The
        Bank
        sold no investment or mortgage-backed securities available for sale during
        fiscal 2007 or fiscal 2006.
 
 Goodwill
        related to prior period acquisitions was $4.2 million at December 31, 2007
        and
        2006, respectively, and is not amortized according to provisions of financial
        accounting standards. The unamortized balance of the Company’s goodwill is
        tested for impairment quarterly. The Company has performed quarterly impairment
        tests and determined there was no impairment of goodwill as of December 31,
        2007
        or December 31, 2006.
 
 Total
        deposits declined to $761.4 million at December 31, 2007 from $800.2 million
        at
        December 31, 2006. The Bank continues to compete in its market area for lower
        costing core demand deposits. During 2007 and amid intense competition, demand
        accounts declined to $243.6 million at December 31, 2007 from $264.7 million
        at
        December 31, 2006. Certificates of deposit declined to $500.2 million at
        December 31, 2007 from $517.0 million at December 31, 2006. The Bank attempts
        to
        manage its cost of deposits by monitoring the volume and rates being paid
        on
        maturing certificates of deposits in relationship to current funding needs
        and
        competitive market interest rates. During fiscal 2007, a period of declining
        Fed
        rate adjustments, the Bank implemented a strategy to not renew certain maturing
        high rate time deposits. The Bank repriced certain new and maturing time
        deposits at competitive market rates and also replaced certain maturing higher
        costing time deposits with lower costing FHLB borrowings, providing an effective
        means of managing its overall cost of funds.
 
 Total
        borrowings increased to $52.4 million at December 31, 2007 from $21.4 million
        at
        December 31, 2006. FHLB advances increased to $35.0 million at December 31,
        2007
        from $6.0 million at December 31, 2006, as a result of implementing the above
        strategy. Junior subordinated debentures were $10.3 million at December 31,
        2007
        and 2006, respectively. Repurchase agreements representing funds held in
        cash
        management accounts for commercial banking customers increased to $7.1 million
        at December 31, 2007 from $5.1 million at December 31, 2006.
  11
 
 Stockholders'
        equity increased to $86.0 million at December 31, 2007, from $78.8 million
        at
        December 31, 2006. The Company’s equity to assets ratio increased to 9.5% at
        December 31, 2007 from 8.7% at December 31, 2006. Accumulated other
        comprehensive income was $377,000 at December 31, 2007, compared to $579,000
        of
        accumulated other comprehensive loss at December 31, 2006, reflecting an
        increase in unrealized gains on available for sale securities, net of deferred
        income taxes. The increase in accumulated other comprehensive income is due
        primarily from a decline in interest rates during the fourth quarter of 2007,
        resulting from downward Fed interest rate adjustments.
 
 During
        fiscal 2007 and 2006, the Company declared four quarterly cash dividends
        each,
        totaling $0.76 and $0.68 per share respectively. These cash dividend payments
        reflect dividend payout ratios on basic earnings of 44.4% for fiscal 2007
        and
        38.4% for fiscal 2006. Future quarterly dividends will be determined at the
        discretion of the Board of Directors based upon earnings, the capital and
        financial condition of the Company, and general economic conditions.
 
 Pursuant
        to stock repurchase programs adopted by the Company during fiscal years 2007
        and
        2006, the Company acquired 244,198 and 24,537 shares of its common stock,
        respectively, through both open market and private purchases. Shares acquired
        under the repurchase program are being held as treasury stock, at cost. At
        December 31, 2007, treasury shares were 1,445,567 totaling $30.9 million,
        compared to 1,466,089 shares totaling $29.1 million at December 31, 2006.
        The
        Company will use the repurchased shares of its outstanding common stock for
        general corporate purposes including the future exercise of stock options
        and
        funding shares issued pursuant to potential future stock splits.
 
 During
        fiscal 2007 and 2006, 303,080 and 532,979 shares, respectively, were issued
        on
        the exercise of stock options. In addition, during fiscal 2007 and 2006,
        38,360
        and 151,695 shares were tendered to pay for the exercise price of stock options
        being exercised and income taxes incident to such option exercises.
 
 ***Comparison
        of Operating Results for the Years Ended December 31, 2007 and
        2006***
 
 *Net
        Income* .
        Net
        income was $17.0 million for the year ended December 31, 2007, compared to
        $17.2
        million for the year ended December 31, 2006. Basic earnings per share were
        $1.71 per share for the year ended December 31, 2007 and $1.77 per share
        for the
        year ended December 31, 2006. Diluted earnings per share were $1.70 per share
        for the year ended December 31, 2007 and $1.72 per share for the year ended
        December 31, 2006. The average numbers of basic shares were 9,914,929 and
        9,714,565 and the average numbers of diluted shares were 10,027,728 and
        10,002,869, respectively, for the years ended December 31, 2007 and 2006.
        Return
        on average assets and return on average equity were 1.9% and 20.3%,
        respectively, for fiscal 2007, compared to 1.9% and 23.5% for fiscal 2006.
 
 *Interest
        Income* .
        Interest income increased to $70.1 million for fiscal 2007 from $67.8 million
        for fiscal 2006. During 2007, a combination of increases in interest rates
        and
        increases in the volume of interest-earning assets enabled the Bank to earn
        an
        increased level of interest income. The average balance of interest-earning
        assets increased to $853.6 million for fiscal 2007, from $834.6 million for
        fiscal 2006. The yield on average interest-earning assets was 8.2% and 8.1%
        for
        fiscal 2007 and 2006, respectively.
 
 *Interest
        Expense* .
        Interest expense increased to $29.1 million for fiscal 2007 from $25.6 million
        for fiscal 2006. The increase in interest expense also reflects increases
        in
        interest rates and increases in the volume of average interest-bearing
        liabilities, plus a decline in noninterest-bearing demand deposits. The average
        balance of interest-bearing liabilities increased to $708.9 million for fiscal
        2007 from $700.1 million for fiscal 2006, while the average balance of
        noninterest-bearing demand deposits declined to $103.6 million for fiscal
        2007
        from $104.7 million for fiscal 2006. The average cost of funds (including
        noninterest-bearing deposits) was 3.6% for 2007, compared to 3.2% for 2006,
        reflecting the rising interest rate environment from 2006 to 2007, combined
        with
        the increased volume of average interest-bearing liabilities.
 
 *Net
        Interest Income* .
        Net
        interest income declined to $41.0 million for fiscal 2007 from $42.1 million
        for
        fiscal 2006. The decline in net interest income during 2007 is attributable
        to a
        $2.2 million greater volume of interest paid on interest-bearing liabilities
        due
        to changing interest rates, than on interest received from interest earning
        assets. The net yield on interest-earning assets (net interest income divided
        by
        average interest-earning assets) was 4.8% and 5.1% for fiscal 2007 and 2006,
        respectively. The Bank's interest rate spread (the difference between the
        effective yield on average interest-earning assets and the effective average
        cost of funds) was 4.6% for fiscal 2007, compared to 4.9% for fiscal 2006.
        See
        Table 3 - Rate/Volume Analysis and Table 4 - Yield/Cost Analysis above for
        additional information on interest income, interest expense, net interest
        income, average balances and yield/cost ratios.
  12
 
 *Provision
        for Credit Losses* .
        The
        Bank provided $350,000 for credit losses during fiscal 2007, compared to
        $933,000 for fiscal 2006. These provisions were necessary to absorb probable
        losses in the loan and lease portfolio, and to support the inherent risks
        associated with the growth of the commercial and consumer loan and lease
        receivable portfolio. The Bank maintains both general and specific allowances
        for loan and lease losses and unfunded loan commitments (collectively the
        allowance for credit losses) based upon management's evaluation of risk in
        the
        loan and lease portfolio, unfunded loan commitments and past loss experience.
        The Bank's methodology for evaluating its allowance for credit losses includes
        amounts specifically allocated to loans and leases that are individually
        determined to be impaired, and general allowances allocated to groups of
        loans
        and leases not individually assessed for impairment. The allowance for loan
        and
        lease losses and unfunded loan commitments was $9.5 million and $403,000,
        respectively, at December 31, 2007, compared to $9.2 million and $765,000
        at
        December 31, 2006. The ratio of the allowance for credit losses to total
        loans
        and leases was 1.3% at December 31, 2007 and 2006, respectively, which the
        Bank
        believes is adequate.
 
 The
        Bank
        uses an analytical asset classification process to determine the adequacy
        of its
        allowance for credit losses and necessary provisions for credit losses. The
        loan
        and lease portfolio is reviewed quarterly and delinquent loans are individually
        analyzed. Consideration is given to the loan status, payment history, repayment
        ability, probability of repayment, and loan-to-value percentages. Loans are
        classified in categories applicable to their circumstances as a result of
        this
        analysis. After reviewing current economic conditions, changes in delinquency
        status, and actual losses incurred by the Bank, management establishes an
        appropriate allowance percentage applicable to each category of assets, and
        provisions for credit losses are recorded when necessary to bring the allowances
        to a level consistent with this analysis.
 
 Nonperforming
        loans were $7.6 million at December 31, 2007, compared to $2.7 million at
        December 31, 2006. The increase in nonperforming loans consist primarily
        of
        three commercial borrowers (residential and commercial real estate developers),
        with total exposure of $5.9 million at December 31, 2007. The largest single
        nonperforming loan totaling $3.0 had a foreclosure sale in the December 2007
        quarter, had two successive upset bids, and was resolved in the first quarter
        of
        2008. The other two credits involve a single family home developer and a
        residential subdivision developer with land and developed building lots,
        which
        may not be resolved until the first half of 2008, and there are also no
        guarantees or assurances that they will be resolved without loss. As a result
        of
        the volume of nonperforming loans, the Bank’s unrecognized interest increased to
        $506,000 at December 31, 2007 from $143,000 at December 31, 2006. The ratio
        of
        non-performing loans to total loans was 1.0% at December 31, 2007, compared
        to
        .4% at December 31, 2006.
 
 *Noninterest
        Income* .
        Noninterest income increased to $10.1 million for fiscal 2007 from $9.3 million
        for fiscal 2006. Other income consists of fees, service charges and servicing
        fees earned on loans, service charges and insufficient funds fees collected
        on
        deposit accounts, gains from sales of loans and other miscellaneous income.
        Fees
        and service charges increased to $7.3 million for fiscal 2007 from $6.7 million
        for fiscal 2006. Fees, service charges earned and insufficient funds fees
        collected during the respective periods is attributable to the volume of
        loan,
        deposit account, and insufficient funds transactions processed during each
        period, and the collection of related fees and service charges.  Servicing
        fee income on loans serviced for others declined to $651,000 for fiscal 2007
        from $666,000 for fiscal 2006. Loans serviced for others were $254.7 million
        at
        December 31, 2007, compared to $245.6 million at December 31, 2006.
 
 Gains
        from sales of mortgage loans increased to $519,000 for fiscal 2007 from $330,000
        for fiscal 2006. The volume of loans sold or exchanged for mortgage-backed
        securities during fiscal 2007 was $42.2 million, compared to $18.4 million
        sold
        during fiscal 2006. The Bank may sell certain held for sale mortgage loans
        during favorable interest rate windows, while retaining other current held
        for
        sale mortgage loan originations for securitization into available for sale
        mortgage-backed securities. In addition, the sale of mortgage loans also
        provides liquidity necessary to support the Bank’s operating, financing and
        lending activities.
 
 *Noninterest
        Expenses* .
        Noninterest expenses increased to $22.9 million for fiscal 2007 from $22.2
        million in fiscal 2006. The Company's efficiency ratio (noninterest expenses
        as
        a percentage of net interest income plus noninterest income) was 45.0% for
        fiscal 2007 compared to 43.1% for fiscal 2006. The efficiency ratio measures
        the
        proportion of net operating revenues that are absorbed by overhead
        expenses.
 
 The
        largest single component of these expenses, compensation and fringe benefits,
        increased to $14.0 million for fiscal 2007 from $13.6 million for fiscal
        2006.
        Full-time equivalent employees were 287 at December 31, 2007 compared to
        275 at
        December 31, 2006. The net growth in personnel results from opening two
        full-service banking offices and two loan production offices in 2007 and
        administrative staff required to support these new offices.
  13
  Data
        processing expense has grown proportionately with the growth in customer
        accounts and transaction activity primarily attributable to the growth in
        earning assets and deposits. Other noninterest expenses including advertising,
        deposit insurance, premises and equipment, payroll and other taxes, repairs
        and
        maintenance, and office expenses have also grown from period to period in
        conjunction with the growth in earning assets and deposit accounts.
  *Income
        Taxes* .
        The
        provision for income taxes declined to $10.8 million for fiscal 2007 from
        $11.1
        million for fiscal 2006. The decline in provision for income taxes is primarily
        the result of the net decline of pretax earnings to $27.8 million for fiscal
        2007 from $28.3 million for fiscal 2006. Changes in the amount of income
        tax
        provisions reflect changes in pretax income and expenses, the application
        of
        permanent and temporary differences, and the income tax rates in effect during
        each period. The effective income tax rates for fiscal 2007 and 2006 were
        38.9%
        and 39.2%, respectively.
 
 ***Comparison
        of Operating Results for the Years Ended December 31, 2006 and
        2005***
 
 *Net
        Income* .
        Net
        income increased to $17.2 million for the year ended December 30, 2006 from
        $14.1 million for the year ended December 31, 2005. Diluted earnings per
        share
        increased to $1.72 per share for the year ended December 31, 2006 from $1.41
        per
        share for the year ended December 31, 2005. The average number diluted shares
        were 10,002,869 and 9,980,222, respectively, for the years ended December
        31,
        2006 and 2005. Return on average assets and return on average equity were
        1.9%
        and 23.5% respectively for fiscal 2006, compared to 1.8% and 21.9% for fiscal
        2005.
 
 *Interest
        Income* .
        Interest income increased to $67.8 million for fiscal 2006 from $53.2 million
        for fiscal 2005. During 2006 the increase in interest income resulted from
        a
        combination of an increase in interest rates and the increase in the volume
        of
        interest-earning assets, enabling the Bank to earn an increased level of
        interest income. The average balance of interest-earning assets increased
        to
        $834.6 million for fiscal 2006, from $738.1 million for fiscal 2005. The
        yield
        on average interest-earning assets was 8.1% and 7.2% for 2006 and 2005,
        respectively.
 
 *Interest
        Expense* .
        Interest expense increased to $25.6 million for fiscal 2006 from $15.5 million
        for fiscal 2005. The increase in interest expense also reflects the increase
        in
        interest rates and the increase in the volume average interest-bearing
        liabilities, offset by an increase in noninterest-bearing checking accounts.
        The
        average balance of interest-bearing liabilities increased to $700.1 million
        for
        fiscal 2006 from $622.0 million for fiscal 2005. The average balance of
        noninterest-bearing deposits increased to $104.7 million for fiscal 2006
        from
        $94.7 million for fiscal 2005. The average cost of funds was 3.2% for 2006,
        compared to 2.2% for 2005, reflecting a rising interest rate environment
        during
        fiscal 2006 and 2005.
 
 *Net
        Interest Income* .
        Net
        interest income increased to $42.1 million for fiscal 2006 from $37.7 million
        for fiscal 2005. The increase in net interest income during 2006 is attributable
        to a $4.6 million greater increase in the volume of average interest-earning
        assets as compared to the increase in the volume of interest-bearing
        liabilities, and the increase in noninterest-bearing deposits. The net yield
        on
        interest-earning assets was 5.1% for both fiscal 2006 and 2005, respectively.
        The Bank's interest rate spread was 4.9% for fiscal 2006, compared to 5.0%
        for
        fiscal 2005.
 
 *Provision
        for Credit Losses* .
        The
        Bank provided $933,000 for credit losses during fiscal 2006, compared to
        $1.7
        million for fiscal 2005. These provisions were necessary to absorb probable
        losses in the loan portfolio and to support the inherent risks associated
        with
        growth in commercial and consumer loans. The Bank maintains an allowance
        for
        loan and lease losses and unfunded commitments (collectively the allowance
        for
        credit losses) based upon management's evaluation of risk in the loan and
        lease
        receivable portfolio and past loss experience. The allowance for loan and
        lease
        losses was $9.2 million at December 31, 2006 and $8.1 million at December
        31,
        2005, and the allowance for unfunded commitments was $765,000 at December
        31,
        2006 and $1.1 million at December 31, 2005. The ratio of the allowance for
        credit losses to total loans was 1.3% at both December 31, 2006 and December
        31,
        2005, respectively, which the Bank believes is adequate. The ratio of
        non-performing loans to total loans was .4% at December 31, 2006 and .3%
        at
        December 31, 2005.
  *Noninterest
        Income* .
        Noninterest income increased to $9.3 million for fiscal 2006 from $8.2 million
        for fiscal 2005. Fees and service charges increased to $6.7 million for fiscal
        2006 from $6.1 million for fiscal 2005, reflecting the volume of loan, deposit
        account, and insufficient funds transactions processed during each period,
        and
        the collection of related fees and service charges. Servicing fee income
        on
        loans serviced for others declined to $666,000 for fiscal 2006 from $684,000
        for
        fiscal 2005, as loans serviced for others declined to $245.6 million at year
        end
        2006 from $260.6 million at year end 2005.
  Gains
        from sales of loans, investments and mortgage-backed securities increased
        to
        $330,000 for fiscal 2006 from $199,000 for fiscal 2005.  The
        volume of loans and mortgage-backed securities sold during fiscal 2006 was
        $18.4
        million, compared to $29.2 million sold during fiscal 2005, reflecting a
        strategy to retain current held for sale mortgage loan originations for
        securitization into available for sale mortgage-backed securities. In addition,
        loan sales provide liquidity necessary to support the Bank’s operating,
        financing and lending activities.
 
 14
  *Noninterest
        Expenses* .
        Noninterest expenses increased to $22.2 million for fiscal 2006 from $21.1
        million in fiscal 2005. The Company's efficiency ratio improved to 43.1%
        for
        fiscal 2006 compared to 46.0% for fiscal 2005.
 
 The
        largest single component of these expenses is compensation and fringe benefits,
        which increased to $13.6 million for fiscal 2006 from $12.7 million for fiscal
        2005. Full-time equivalent employees increased to 275 at December 31, 2006
        from
        270 at December 31, 2005. This growth is due to additional personnel resulting
        from purchasing three full-service banking offices in 2005 and administrative
        staff required to support the $76.3 million net growth in assets during fiscal
        2006.
 
 Data
        processing expense has grown proportionately with the growth in customer
        accounts and transaction activity primarily attributable to the growth in
        earning assets and deposits. Other noninterest expenses including advertising,
        deposit insurance, premises and equipment, payroll and other taxes, repairs
        and
        maintenance, and office expenses have also grown from period to period in
        conjunction with the growth in earning assets and deposit accounts.
 
 *Income
        Taxes* .
        The
        provision for income taxes increased to $11.1 million for fiscal 2006 from
        $8.9
        million for fiscal 2005. The increase in provision for income taxes is primarily
        the result of the increase of pretax earnings to $28.3 million for fiscal
        2006
        from $23.1 million for fiscal 2005. Changes in the amount of income tax
        provisions reflect changes in pretax income and expenses, the application
        of
        permanent and temporary differences, and the income tax rates in effect during
        each period. The effective income tax rates for fiscal 2006 and 2005 were
        39.2%
        and 38.8%, respectively.
  **Impact
        of Inflation and Changing Prices** **.** The
        financial statements of the Bank and accompanying footnotes have been prepared
        in accordance with generally accepted accounting principles. They require
        the
        measurement of financial position and operating results in terms of historical
        dollars without considering the change in the relative purchasing power of
        money
        over time and due to inflation. The impact of inflation is reflected in the
        increased cost of the Bank's operations. Unlike most industrial companies,
        nearly all the assets and liabilities of the Bank are monetary. As a result,
        interest rates have a greater impact on the Bank's performance than do the
        effects of general levels of inflation. Interest rates do not necessarily
        move
        in the same direction or to the same extent as the price of goods and
        services.
 
 **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, including the Letter to Stockholders
        and Management's Discussion and Analysis of Financial Condition and Results
        of
        Operations, 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.
 
 **Off-Balance
        Sheet Arrangements** **.** ****** **** See
        Note
        14 of the “Notes to Consolidated Financial Statements” for a description of
        financial instruments with off-balance sheet risk to which the Bank is a
        party
        in the normal course of business to meet the financing needs of its customers
        and to reduce its own exposure to fluctuations in interest rates. These
        financial instruments include commitments to extend credit and involve, to
        varying degrees, elements of credit and interest rate risk in excess of the
        amount recognized in the consolidated balance sheet.
 
 **New
        Accounting Pronouncements.** See Note
        1 of the “Notes to Consolidated Financial Statements” for a description of new
        accounting pronouncements including the respective effective dates of adoption
        and effects on results of operations and financial condition.
  15




**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





(Letterhead
      of Turlington and Company, L.L.P.)




To
      the
      Stockholders and the Board of Directors


First
      South Bancorp, Inc.


Washington,
      North Carolina





We
      have
      audited the accompanying consolidated statements of financial condition of
      First
      South Bancorp, Inc. and Subsidiary as of December 31, 2007 and 2006, and the
      related consolidated statements of operations, changes in stockholders' equity,
      and cash flows for the years ended December 31, 2007 and 2006. These
      consolidated financial statements are the responsibility of the Company's
      management. Our responsibility is to express an opinion on these consolidated
      financial statements based on our audits. The consolidated financial statements
      of First South Bancorp, Inc. and Subsidiary for the year ended December 31,
      2005
      were audited by other auditors whose report dated March 7, 2006 (except for
      the
      stock split described in Note 1 as to which the date is May 25, 2006) expressed
      an unqualified opinion on those statements.





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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of First South Bancorp, Inc.
      and Subsidiary at December 31, 2007 and 2006 and the results of their
      operations, and their cash flows for the years ended December 31, 2007 and
      2006
      in conformity with accounting principles generally accepted in the United States
      of America.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), First South Bancorp, Inc.'s internal control
      over financial reporting as of December 31, 2007, based on criteria established
      in *Internal
      Control - Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission (COSO),
      and our report dated March 5, 2008 expressed an unqualified
      opinion.





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





Lexington,
      North Carolina


March
      5,
      2008





16





**FIRST
      SOUTH BANCORP, INC. AND****SUBSIDIARY**


***CONSOLIDATED
      STATEMENTS OF FINANCIAL CONDITION***


***December
      31, 2007 and 2006***





2007
            
            2006**ASSETS**Cash
                and due from banks
            
            $
            22,273,592
            
            $
            24,608,819Interest-bearing
                deposits in financial institutions
            
            
            1,755,695
            
            
            1,194,801Investment
                securities - available for sale
            
            
            49,064,278
            
            
            56,454,127Mortgage-backed
                securities - available for sale
            
            
            37,828,064
            
            
            35,066,627Mortgage-backed
                securities - held for investment
            
            
            1,291,762
            
            
            1,662,540Loans
                receivable, netHeld
                for sale
            
            
            7,515,626
            
            
            25,576,080Held
                for investment
            
            
            757,567,279
            
            
            735,860,969Premises
                and equipment, net
            
            
            9,433,399
            
            
            8,898,009Real
                estate owned
            
            
            1,601,704
            
            
            634,434Federal
                  Home Loan Bank of Atlanta stock, at costwhich
                  approximates market
            
            
            3,210,100
            
            
            1,933,300Accrued
                interest receivable
            
            
            5,103,405
            
            
            5,398,477Goodwill
            
            
            4,218,576
            
            
            4,218,576Mortgage
                servicing rights
            
            
            1,150,616
            
            
            1,266,530Identifiable
                intangible assets
            
            
            196,500
            
            
            227,940Income
                tax receivable
            
            
            1,403,567
            
            
            1,605,102Prepaid
                expenses and other assets
            
            
            5,673,548
            
            
            5,941,574Total
                assets
            
            $
            909,287,711
            
            $
            910,547,905**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Deposits:Demand
            
            $
            243,647,606
            
            $
            264,722,202Savings
            
            
            17,497,763
            
            
            18,481,271Large
                denomination certificates of deposit
            
            
            204,509,581
            
            
            181,078,901Other
                time
            
            
            295,714,633
            
            
            335,906,107Total
                deposits
            
            
            761,369,583
            
            
            800,188,481Borrowed
                money
            
            
            42,067,421
            
            
            11,139,947Junior
                subordinated debentures
            
            
            10,310,000
            
            
            10,310,000Other
                liabilities
            
            
            9,505,385
            
            
            10,112,899Total
                liabilities
            
            
            823,252,389
            
            
            831,751,327Commitments
                and contingencies (Note 14)Common
                    stock, $.01 par value, 25,000,000 shares authorized,11,254,222
                    issued; 9,808,655 and 9,788,133shares
                    outstanding, respectively
            
            
            98,087
            
            
            97,881Additional
                paid-in capital
            
            
            36,761,824
            
            
            38,165,536Retained
                earnings, substantially restricted
            
            
            79,679,027
            
            
            70,217,380Treasury
                stock at cost
            
            
            (30,880,120
            )
            
            (29,104,894
            )Accumulated
                other comprehensive income (loss), net
            
            
            376,504
            
            
            (579,325
            )Total
                stockholders' equity
            
            
            86,035,322
            
            
            78,796,578Total
                liabilities and stockholders' equity
            
            $
            909,287,711
            
            $
            910,547,905




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


17





**FIRST
      SOUTH BANCORP, INC. AND****SUBSIDIARY**


***CONSOLIDATED
      STATEMENTS OF OPERATIONS***


***Years
      Ended December 31, 2007, 2006 and 2005***







2007
            
            2006
            
            2005Interest
                incomeInterest
                and fees on loans
            
            $
            64,975,487
            
            $
            63,198,115
            
            $
            50,357,203Interest
                and dividends on investments and deposits
            
            
            5,102,761
            
            
            4,553,439
            
            
            2,818,847Total
                interest income
            
            
            70,078,248
            
            
            67,751,554
            
            
            53,176,050Interest
                expenseInterest
                on deposits
            
            
            27,499,996
            
            
            23,858,628
            
            
            14,542,548Interest
                on borrowings
            
            
            771,976
            
            
            932,559
            
            
            288,329Interest
                on junior subordinated debentures
            
            
            839,110
            
            
            815,331
            
            
            632,629Total
                interest expense
            
            
            29,111,082
            
            
            25,606,518
            
            
            15,463,506Net
                interest income before provision for credit losses
            
            
            40,967,166
            
            
            42,145,036
            
            
            37,712,544Provision
                for credit losses
            
            
            350,000
            
            
            932,878
            
            
            1,711,197Net
                interest income
            
            
            40,617,166
            
            
            41,212,158
            
            
            36,001,347Other
                incomeFees
                and service charges
            
            
            7,341,240
            
            
            6,723,391
            
            
            6,116,949Loan
                servicing fees
            
            
            651,358
            
            
            666,032
            
            
            684,135Gain
                on sale of real estate, net
            
            
            49,644
            
            
            10,237
            
            
            215,928Gain
                on sale of mortgage loans
            
            
            519,361
            
            
            329,743
            
            
            199,414Other
                income
            
            
            1,575,171
            
            
            1,529,644
            
            
            990,165Total
                other income
            
            
            10,136,774
            
            
            9,259,047
            
            
            8,206,591General
                and administrative expensesCompensation
                and fringe benefits
            
            
            13,973,012
            
            
            13,582,647
            
            
            12,682,779Federal
                insurance premiums
            
            
            94,349
            
            
            95,012
            
            
            89,523Premises
                and equipment
            
            
            1,938,555
            
            
            1,776,903
            
            
            1,761,934Advertising
            
            
            125,490
            
            
            207,246
            
            
            187,536Payroll
                and other taxes
            
            
            1,308,248
            
            
            1,305,008
            
            
            1,143,214Data
                processing
            
            
            2,524,983
            
            
            2,362,751
            
            
            2,270,449Amortization
                of intangible assets
            
            
            394,508
            
            
            375,463
            
            
            403,999Other
            
            
            2,551,831
            
            
            2,502,015
            
            
            2,592,604Total
                general and administrative expenses
            
            
            22,910,976
            
            
            22,207,045
            
            
            21,132,038Income
                before income taxes
            
            
            27,842,964
            
            
            28,264,160
            
            
            23,075,900Income
                taxes
            
            
            10,839,737
            
            
            11,071,804
            
            
            8,947,196NET
                INCOME
            
            
            17,003,227
            
            
            17,192,356
            
            
            14,128,704Other
                comprehensive income (loss), net of taxes
            
            
            955,829
            
            
            (208,408
            )
            
            (1,244,045
            )Comprehensive
                income
            
            $
            17,959,056
            
            $
            16,983,948
            
            $
            12,884,659Net
                income per common shareBasic
            
            $
            1.71
            
            $
            1.77
            
            $
            1.49Diluted
            
            $
            1.70
            
            $
            1.72
            
            $
            1.41


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


18





**FIRST
      SOUTH BANCORP, INC. AND****SUBSIDIARY**


***CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY***


***Years
      Ended December 31, 2007, 2006 and 2005***







Common
              stock
            
            Additional
              paid-in
              capital
            
            Retained
              earnings,
              substantially
              restricted
            
            Treasury
              stock
            
            Accumulated
              other
              comprehensive
              income
              (loss),
                net
            
            TotalBalance,
                December 31, 2004
            
            $
            62,647
            
            $
            37,815,715
            
            $
            50,597,651
            
            $
            (29,653,794
            )
            $
            873,128
            
            $
            59,695,347Net
                income
            
            
            -
            
            
            -
            
            
            14,128,704
            
            
            -
            
            
            -
            
            
            14,128,704Other
                comprehensive loss, net
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,244,045
            )
            
            (1,244,045
            )Exercise
                of stock options
            
            
            1,017
            
            
            (1,060,993
            )
            
            -
            
            
            1,741,721
            
            
            -
            
            
            681,745Tax
                benefit, stock options exercised
            
            
            -
            
            
            490,923
            
            
            -
            
            
            -
            
            
            -
            
            
            490,923Shares
                traded to exercise options
            
            
            (176
            )
            
            379,249
            
            
            -
            
            
            (539,273
            )
            
            -
            
            
            (160,200
            )Acquisition
                of treasury shares
            
            
            (93
            )
            
            -
            
            
            -
            
            
            (336,633
            )
            
            -
            
            
            (336,726
            )Dividends
                ($.53 per share)
            
            
            -
            
            
            -
            
            
            (5,065,276
            )
            
            -
            
            
            -
            
            
            (5,065,276
            )Balance,
                December 31, 2005
            
            
            63,395
            
            
            37,624,894
            
            
            59,661,079
            
            
            (28,787,979
            )
            
            (370,917
            )
            
            68,190,472Net
                income
            
            
            -
            
            
            -
            
            
            17,192,356
            
            
            -
            
            
            -
            
            
            17,192,356Other
                comprehensive loss, net
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (208,408
            )
            
            (208,408
            )Exercise
                of stock options
            
            
            3,706
            
            
            (5,963,302
            )
            
            -
            
            
            6,605,460
            
            
            -
            
            
            645,864Tax
                benefit, stock options exercised
            
            
            -
            
            
            3,965,214
            
            
            -
            
            
            -
            
            
            -
            
            
            3,965,214Shares
                traded to exercise options
            
            
            (1,517
            )
            
            2,412,280
            
            
            -
            
            
            (6,054,715
            )
            
            -
            
            
            (3,643,952
            )Acquisition
                of treasury shares
            
            
            (245
            )
            
            -
            
            
            -
            
            
            (867,660
            )
            
            -
            
            
            (867,905
            )Stock
                based compensation
            
            
            -
            
            
            126,450
            
            
            -
            
            
            -
            
            
            -
            
            
            126,450Dividends
                ($.68 per share)
            
            
            -
            
            
            -
            
            
            (6,594,848
            )
            
            -
            
            
            -
            
            
            (6,594,848
            )3-for-2
                stock split
            
            
            32,542
            
            
            -
            
            
            (41,207
            )
            
            -
            
            
            -
            
            
            (8,665
            )Balance,
                December 31, 2006
            
            
            97,881
            
            
            38,165,536
            
            
            70,217,380
            
            
            (29,104,894
            )
            
            (579,325
            )
            
            78,796,578Net
                income
            
            
            -
            
            
            -
            
            
            17,003,227
            
            
            -
            
            
            -
            
            
            17,003,227Other
                comprehensive income, net
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            955,829
            
            
            955,829Exercise
                of stock options
            
            
            3,031
            
            
            (4,740,120
            )
            
            -
            
            
            6,093,153
            
            
            -
            
            
            1,356,064Tax
                benefit, stock options exercised
            
            
            -
            
            
            2,430,435
            
            
            -
            
            
            -
            
            
            -
            
            
            2,430,435Shares
                traded to exercise options
            
            
            (383
            )
            
            822,209
            
            
            -
            
            
            (1,148,545
            )
            
            -
            
            
            (326,719
            )Acquisition
                of treasury shares
            
            
            (2,442
            )
            
            -
            
            
            -
            
            
            (6,719,834
            )
            
            -
            
            
            (6,722,276
            )Stock
                based compensation
            
            
            -
            
            
            83,764
            
            
            -
            
            
            -
            
            
            -
            
            
            83,764Dividends
                ($.76 per share)
            
            
            -
            
            
            -
            
            
            (7,541,580
            )
            
            -
            
            
            -
            
            
            (7,541,580
            )Balance,
                December 31, 2007
            
            $
            98,087
            
            $
            36,761,824
            
            $
            79,679,027
            
            $
            (30,880,120
            )
            $
            376,504
            
            $
            86,035,322


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





19





**FIRST
      SOUTH BANCORP, INC. AND****SUBSIDIARY**


***CONSOLIDATED
      STATEMENTS OF CASH FLOWS***


***Years
      Ended December 31, 2007, 2006 and 2005***





2007
            
            2006
            
            2005Operating
                activitiesNet
                income
            
            $
            17,003,227
            
            $
            17,192,356
            
            $
            14,128,704Adjustments
                  to reconcile net income to net
                cash
                  provided by (used in) operating activitiesProvision
                for credit losses
            
            
            350,000
            
            
            932,878
            
            
            1,711,197Depreciation
            
            
            813,510
            
            
            843,017
            
            
            839,387Amortization
                of intangibles
            
            
            394,508
            
            
            375,463
            
            
            403,999Accretion
                of discounts on securities, net
            
            
            (12,849
            )
            
            59,769
            
            
            (84,657
            )Deferred
                income taxes
            
            
            (438,860
            )
            
            (201,747
            )
            
            (546,141
            )Gain
                  on disposal of premises and equipmentand
                  real estate owned
            
            
            (206,891
            )
            
            (157,856
            )
            
            (258,741
            )Gain
                  on loans held for sale and mortgage-backed
                  securities
            
            
            (519,361
            )
            
            (329,743
            )
            
            (199,414
            )Stock
                based compensation expense
            
            
            83,764
            
            
            126,450
            
            
            -Originations
                of loans held for sale, net
            
            
            (23,668,607
            )
            
            (32,791,666
            )
            
            (33,898,697
            )Proceeds
                from sale of loans held for sale
            
            
            35,374,932
            
            
            1,187,887
            
            
            12,859,144Other
                operating activities
            
            
            (459,284
            )
            
            (1,936,077
            )
            
            156,243Net
                cash provided by (used in) operating activities
            
            
            28,714,089
            
            
            (14,699,269
            )
            
            (4,888,976
            )Investing
                activitiesProceeds
                  from maturities of investment securitiesavailable
                  for sale
            
            
            9,000,000
            
            
            10,050,000
            
            
            16,000,000Purchases
                of investment securities available for sale
            
            
            (500,000
            )
            
            (25,000,000
            )
            
            (27,000,000
            )Proceeds
                  from principal repayments and sales ofmortgage-backed
                  securities available for sale
            
            
            4,579,831
            
            
            2,682,350
            
            
            1,663,783Proceeds
                  from principal repayments ofmortgage-backed
                  securities held for investment
            
            
            370,778
            
            
            400,770
            
            
            506,048Originations
                  of loans held for investment, netof
                  principal repayments
            
            
            (23,651,034
            )
            
            (39,762,587
            )
            
            (73,624,172
            )Proceeds
                  from disposal of premises and equipmentand
                  real estate owned
            
            
            1,192,808
            
            
            847,830
            
            
            1,229,700Sales
                (purchases) of FHLB stock
            
            
            (1,276,800
            )
            
            (244,100
            )
            
            136,000Purchases
                of premises and equipment
            
            
            (1,707,363
            )
            
            (1,094,382
            )
            
            (1,193,777
            )Repayment
                of note receivable
            
            
            -
            
            
            -
            
            
            1,156,557Net
                cash used in investing activities
            
            
            (11,991,780
            )
            
            (52,120,119
            )
            
            (81,125,861
            )Financing
                activitiesNet
                increase (decrease) in deposit accounts
            
            
            (38,818,898
            )
            
            66,435,416
            
            
            105,216,360Net
                increase (decrease) in FHLB borrowings
            
            
            29,000,000
            
            
            500,000
            
            
            (5,000,000
            )Purchase
                of treasury shares
            
            
            (6,722,276
            )
            
            (867,905
            )
            
            (336,726
            )Proceeds
                from exercise of stock options, net of tax benefit
            
            
            3,459,780
            
            
            967,126
            
            
            1,012,468Cash
                paid for dividends and fractional shares
            
            
            (7,342,722
            )
            
            (6,207,440
            )
            
            (4,867,849
            )Net
                change in repurchase agreements
            
            
            1,927,474
            
            
            (1,147,581
            )
            
            1,995,628Net
                cash provided by (used in) financing activities
            
            
            (18,496,642
            )
            
            59,679,616
            
            
            98,019,881Increase
                (decrease) in cash and cash equivalents
            
            
            (1,774,333
            )
            
            (7,139,772
            )
            
            12,005,044Cash
                and cash equivalents, beginning of year
            
            
            25,803,620
            
            
            32,943,392
            
            
            20,938,348Cash
                and cash equivalents, end of year
            
            $
            24,029,287
            
            $
            25,803,620
            
            $
            32,943,392




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





20





**FIRST
      SOUTH BANCORP, INC. AND****SUBSIDIARY** ****


***NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS***


***As
      of And For The Years Ended December 31, 2007, 2006 and
      2005***





**1.
      BASIS OF PRESENTATION AND ACCOUNTING POLICIES**





**ORGANIZATION
      AND NATURE OF OPERATIONS**





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





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





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





**USE
      OF ESTIMATES**





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





**CASH
      AND CASH EQUIVALENTS**





Cash
      and
      cash equivalents include demand and time deposits (with remaining maturities
      of
      ninety days or less at time of purchase) at other financial institutions.





**INVESTMENTS
      AND MORTGAGE-BACKED SECURITIES**





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





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





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





21





**1.
      BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)**





**LOANS
      RECEIVABLE AND ALLOWANCE FOR CREDIT LOSSES**





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





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





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





A
      loan is
      considered impaired, based on current information and events, if it is probable
      that the Bank will be unable to collect the scheduled payments of principal
      or
      interest when due according to the contractual terms of the loan agreement.
      Uncollateralized loans are measured for impairment based on the present value
      of
      expected future cash flows discounted at the historical effective interest
      rate,
      while all collateral-dependent loans are measured for impairment based on the
      fair value of the collateral. The Bank uses several factors in determining
      if a
      loan is impaired. Internal asset classification procedures include a thorough
      review of significant loans and lending relationships and include the
      accumulation of related data. This data includes loan payment status, borrowers'
      financial data and borrowers' operating factors such as cash flows, operating
      income or loss, etc. At December 31, 2007 and 2006, there were no loans,
      individually or in the aggregate, that are material to the consolidated
      financial statements which were defined as impaired.





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





**LOANS
      HELD FOR SALE**





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





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





22





**1.
      BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)**





**INCOME
      RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS**





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





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





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





**MORTGAGE
      SERVICING RIGHTS**





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





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





The
      Company recorded amortization of mortgage servicing rights of $363,068, $344,023
      and $372,559 for prepayments during the years ended December 31, 2007, 2006
      and
      2005, respectively. There were no impairments recognized during the years ended
      December 31, 2007, 2006 and 2005.





**PREMISES
      AND EQUIPMENT**





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





**REAL
      ESTATE OWNED**





Assets
      acquired through loan foreclosure are recorded as real estate owned at the
      lower
      of the estimated fair value of the property less estimated costs to sell at
      the
      date of foreclosure or the carrying amount of the loan plus unpaid accrued
      interest. The carrying amount is subsequently reduced by additional allowances
      which are charged to earnings if the estimated fair value declines below its
      initial value plus any capitalized costs. Costs related to the improvement
      of
      the property are capitalized, whereas costs related to holding the property
      are
      expensed. There were no valuation adjustments recognized during the years ended
      December 31, 2007, 2006 and 2005.





23





**1.
      BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)**





**INVESTMENT
      IN FEDERAL HOME LOAN BANK STOCK**





The
      Bank
      is required to invest in Class B capital stock, par value $100, of the Federal
      Home Loan Bank of Atlanta (“FHLB”). The FHLB capital stock requirement is based
      on the sum of a membership stock component totaling 20% of the Bank’s total
      assets plus an activity based stock component of 4.5% of outstanding FHLB
      advances. At December 31, 2007 and 2006, the Bank owned 32,101 and 19,333 shares
      of the FHLB’s capital stock, respectively.




The
      Bank
      carries this investment at cost. Due to the redemption provisions of the FHLB,
      the Company estimated that fair value equals cost and that this investment
      was
      not impaired at December 31, 2007.





**GOODWILL
      AND INTANGIBLE ASSETS**





Net
      assets of companies acquired in purchase transactions are recorded at fair
      value
      at the date of acquisition and, as such, the historical cost basis of individual
      assets and liabilities are adjusted to reflect their fair value. Identified
      intangible assets resulting from branch offices acquired in 2004 are amortized
      on a straight-line basis over 10 years. Amortization expense of $31,440 per
      year
      was recorded for the years ended December 31, 2007, 2006 and 2005, respectively.
      Goodwill is not amortized, but is reviewed for potential impairment on an annual
      basis at the reporting unit level. The impairment test is performed in two
      phases. The first step of the goodwill impairment test, used to identify
      potential impairment, compares the fair value of the reporting unit with its
      carrying amount, including goodwill. If the fair value of the reporting unit
      exceeds its carrying amount, goodwill of the reporting unit is considered not
      impaired; however, if the carrying amount of the reporting unit exceeds its
      fair
      value, an additional procedure must be performed. That additional procedure
      compares the implied fair value of the reporting unit's goodwill (as defined
      in
      SFAS No. 142) with the carrying amount of that goodwill. An impairment loss
      is
      recorded to the extent that the carrying amount of goodwill exceeds its implied
      fair value. Other intangible assets are evaluated for impairment if events
      and
      circumstances indicate a possible impairment. Such evaluation of other
      intangible assets is based on undiscounted cash flow projections.





**INCOME
      TAXES**





The
      Company reports income taxes in accordance with Statement of Financial
      Accounting Standards No. 109, *Accounting
      for Income Taxes* ,
      ("SFAS
      No. 109") which requires the recognition of deferred tax assets and liabilities
      for the temporary difference between financial statement and tax basis of the
      Company's assets and liabilities using the enacted tax rates in effect in the
      years in which the differences are expected to reverse. Valuation allowances
      are
      provided if based upon the weight of available evidence, it is more likely
      than
      not that some or all of the deferred tax assets will not be realized.





**ADVERTISING**





Advertising
      costs are expensed as incurred. For the years ended December 31, 2007, 2006
      and
      2005, the Company incurred advertising expense totaling $125,490, $207,246
      and
      $187,536, respectively.





**COMPREHENSIVE
      INCOME**





The
      Company's other comprehensive income relates to unrealized gains (losses) on
      available for sale securities. Information concerning the Company's other
      comprehensive income (loss) for the years ended December 31, 2007, 2006 and
      2005
      is as follows:




Years
                ended December 31,2007
            
            2006
            
            2005Unrealized
                  gains (losses) on securitiesavailable
                  for sale
            
            $
            1,565,079
            
            $
            (357,109
            )
            $
            (2,006,525
            )Income
                tax benefit (expense)
            
            
            (609,250
            )
            
            148,701
            
            
            762,480Other
                comprehensive income (loss), net
            
            $
            955,829
            
            $
            (208,408
            )
            $
            (1,244,045
            )





24





**1.
      BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)**





**SEGMENT
      INFORMATION**





The
      Company follows the provisions of SFAS No. 131, “Disclosure About Segments of an
      Enterprise and Related Information,” which specifies guidelines for determining
      an entity's operating segments and the type and level of financial information
      to be disclosed. Based on these guidelines, management has determined that
      the
      Bank operates in one business segment, the providing of general commercial
      financial services to customers located in its market areas. The various
      products are those generally offered by community banks. The allocation of
      Bank
      resources is based on overall performance of the Bank, rather than individual
      branches or products.




**STOCK
      SPLIT**





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





**NEW
      ACCOUNTING PRONOUNCEMENTS**




In
      February 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      155 (“SFAS No. 155”), “Accounting for Certain Hybrid Financial
      Instruments — an Amendment of FASB Statement No. 133 and 140”.
      This Statement permits fair value remeasurement for any hybrid financial
      instrument that contains an embedded derivative that otherwise would require
      bifurcation; clarifies which interest-only strips and principal-only strips
      are
      not subject to the requirements of SFAS No. 133; establishes a requirement
      to
      evaluate interests in securitized financial assets to identify interests that
      are freestanding derivatives or that are hybrid financial instruments that
      contain an embedded derivative requiring bifurcation; clarifies that
      concentrations of credit risk in the form of subordination are not embedded
      derivatives; and amends SFAS No. 140 to eliminate the prohibition on a
      qualifying special-purpose entity from holding a derivative financial instrument
      that pertains to a beneficial interest other than another derivative financial
      instrument. SFAS No. 155 is effective for all financial instruments acquired
      or
      issued after the beginning of the fiscal years beginning after
      September 15, 2006. The Company adopted SFAS No. 155 on January 1, 2007
      with no material effect on its consolidated financial statements.





In
      March
      2006, the FASB issued Statement of Financial Accounting Standards No. 156
      (“SFAS No. 156”), “Accounting for Servicing of Financial Assets —
an amendment of FASB Statement No. 140”. This Statement requires an
      entity to recognize a servicing asset or servicing liability each time it
      undertakes an obligation to service a financial asset by entering into a
      servicing contract; requires all separately recognized servicing assets and
      servicing liabilities to be initially measured at fair value, if practicable;
      permits an entity to choose either of the Amortization or Fair Value subsequent
      measurement methods for each class of separately recognized servicing assets
      and
      servicing liabilities; and requires separate presentation of servicing assets
      and servicing liabilities measured at fair value in the statement of financial
      position. SFAS No. 156 is effective for fiscal years beginning after
      September 15, 2006. The Company adopted SFAS No. 156 on January 1, 2007
      with no material effect on its consolidated financial statements.





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




25




**1.
      BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)**





**NEW
      ACCOUNTING PRONOUNCEMENTS (Continued)**





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





In
      December 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      160 (“SFAS No. 160”), “Noncontrolling Interests in Consolidated
      Financial Statements - an amendment of ARB No. 51”. The objective of this
      Statement is to improve the relevance, comparability, and transparency of the
      financial information that a reporting entity provides in its consolidated
      financial statements. This Statement requires consolidated net income to be
      reported at amounts that include the amounts attributable to both the parent
      and
      the noncontrolling interest. This Statement establishes a single method of
      accounting for changes in a parent’s ownership interest in a subsidiary that do
      not result in deconsolidation and requires that a parent recognize a gain or
      loss in net income when a subsidiary is deconsolidated. SFAS No. 160 is
      effective for fiscal years beginning after December 15, 2008. The Company
      is currently evaluating the impact SFAS No. 160 may have on its consolidated
      financial statements.





In
      June
      2006, the FASB issued Financial Interpretation No. 48 (“FIN 48”),
“Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement
      No. 109”. This Interpretation prescribes a recognition threshold and
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return; and also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods, disclosure and transition. FIN 48 is effective for fiscal
      years
      beginning after December 15, 2006. The Company adopted FIN 48 on January 1,
      2007 with no material effect on its consolidated financial statements.





In
      November 2007, the SEC issued Staff Accounting Bulletin No. 109, “Miscellaneous
      Accounting - Written Loan Commitments Recorded at Fair Value through Earnings”
(“SAB 109”). SAB 109 addresses written loan commitments that are accounted for
      at fair value through earnings under generally accepted accounting principles.
      This Bulletin supersedes SAB 105, “Accounting for Derivative Instruments and
      Hedging Activities” and concludes that expected net future cash flows related to
      the associated servicing of the loan should be included in the measurement
      of
      all written loan commitments that are accounted for at fair value through
      earnings. SAB 105 indicated that the SEC staff believed that internally
      developed intangible assets should not be recorded as part of the fair value
      of
      a derivative loan commitment. SAB 109 retains that staff view and broadens
      its
      application to all written loan commitments that are accounted for as fair
      value
      through earnings. The SEC expects registrants to apply the views in Question
      1
      of SAB 109 on a prospective basis to derivative loan commitments issued or
      modified in fiscal quarters beginning after December 15, 2007. The Company
      is
      currently evaluating the impact SAB 109 may have on its consolidated financial
      statements.





In
      December 2007, the SEC issued Staff Accounting Bulletin No. 110, “Share-Based
      Payment - Certain Assumptions Used in Valuation Methods - Expected Term” (“SAB
      110”). SAB 110 provides guidance on developing an estimated term of “plain
      vanilla” share options in accordance with SFAS No. 123(r), Share-Based Payment.
      Due to the fact that detailed external information about employees exercise
      behavior may not, as originally thought, be readily available by December 31,
      2007, the SEC staff will continue to accept, under certain circumstances, the
      use of the simplified method beyond December 31, 2007. The Company is currently
      evaluating the impact SAB 110 may have on its consolidated financial statements.





From
      time
      to time, the FASB issues exposure drafts for proposed statements of financial
      accounting standards. Such exposure drafts are subject to comment from the
      public, to revisions by the FASB and to final issuance by the FASB as statements
      of financial accounting standards. Management considers the effect of the
      proposed statements on the consolidated financial statements of the Company
      and
      monitors the status of changes to and proposed effective dates of exposure
      drafts.





26





**2.
      INVESTMENT SECURITIES**





Investment
      securities at December 31, 2007 and 2006 are classified as available for sale
      according to management's intent and summarized as follows:





Amortized
              cost
            
            Gross
              unrealized
              gains
            
            Gross
              unrealized
              losses
            
            Estimated
              market
              valueDecember
                31, 2007:U.S.
                Treasury and Agency Notes
            
            $
            47,944,142
            
            $
            720,303
            
            $
            (13,496
            )
            $
            48,650,949Triangle
                Capital Corporation
            
            
            500,000
            
            
            -
            
            
            (86,671
            )
            
            413,329$
            48,444,142
            
            $
            720,303
            
            $
            (100,167
            )
            $
            49,064,278December
                31, 2006:U.S.
                Treasury and Agency Notes
            
            $
            56,931,292
            
            $
            94,931
            
            $
            (572,096
            )
            $
            56,454,127





Included
      in the Company’s investment securities total are equity securities consisting of
      33,333 shares of restrictive common stock of Triangle Capital Corporation
      (NASDAQ: TCAP) received on February 21, 2007 upon completion of a public
      offering of TCAP. Prior to the public offering, the Company was a limited
      partner in the Triangle Mezzanine Fund, LLLP, with an investment of $500,000.
      In
      the public offering, TCAP acquired Triangle Mezzanine Fund, LLLP, and the
      limited partners received shares of TCAP restricted common stock in amounts
      equivalent to their limited investment in the Triangle Mezzanine Fund, LLLP.
      At
      December 31, 2007, the TCAP equity securities owned by the Company had a market
      value of $413,329. Unrealized loss on Triangle Capital Corporation equity
      security is considered my management to be temporary.





The
      following tables summarize U.S. Treasury and Agency Notes unrealized losses
      and
      fair value, aggregated by length of time that individual securities have been
      in
      a continuous unrealized loss position, at December 31, 2007 and 2006. The
      current year unrealized losses on these investment securities are a result
      of
      volatility in the market during 2007 and relate to two U.S. Treasury and Agency
      Notes. All unrealized losses on U.S. Treasury and Agency Notes are considered
      by
      management to be temporary given the credit ratings on these investment
      securities.





2007Less
                Than 12 Months
            
            12
                Months or More
            
            TotalFair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              lossesSecurities
                available for sale:U.S.
                Treasury and Agency Notes
            
            $
            -
            
            $
            -
            
            $
            7,983,712
            
            $
            (13,496
            )
            $
            7,983,712
            
            $
            (13,496
            )




2006Less
                Than 12 Months
            
            12
                Months or More
            
            TotalFair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              lossesSecurities
                available for sale:U.S.
                Treasury and Agency Notes
            
            $
            14,682,646
            
            $
            (173,527
            )
            $
            26,642,632
            
            $
            (398,569
            )
            $
            41,325,278
            
            $
            (572,096
            )





U.S.
      Treasury and Agency notes at December 31, 2007 are contractually scheduled
      to
      mature as follows:




Amortized
              cost
            
            Estimated
              market
              valueDue
                within one year
            
            $
            13,003,101
            
            $
            13,022,644Due
                after one year through five years
            
            
            34,941,041
            
            
            35,628,305Total
            
            $
            47,944,142
            
            $
            48,650,949





There
      were no sales of U.S. Treasury and Agency Notes during the years ended December
      31, 2007, 2006 and 2005. U.S.
      Treasury and Agency Notes with an amortized cost of approximately $18.8 million
      and $13.4 million were pledged to secure deposits from public entities and
      repurchase agreements at December 31, 2007 and 2006, respectively.





27





**3.
      MORTGAGE-BACKED SECURITIES**





Mortgage-backed
      securities at December 31, 2007 and 2006 are classified as available for sale
      according to management's intent and summarized as follows:





Amortized
              cost
            
            Gross
              unrealized
              gains
            
            Gross
              unrealized
              losses
            
            Estimated
              market
              valueDecember
                31, 2007:FHLMC
                  PCs, maturing fromyears
                  2008 to 2037
            
            $
            37,825,879
            
            $
            305,477
            
            $
            (303,292
            )
            $
            37,828,064December
                31, 2006:FHLMC
                  PCs, maturing fromyears
                  2007 to 2035
            
            $
            35,532,221
            
            $
            135,332
            
            $
            (600,926
            )
            $
            35,066,627





Mortgage-backed
      securities at December 31, 2007 and 2006 are classified as held for investment
      according to management's intent and summarized as follows:




Amortized
              cost
            
            Gross
              unrealized
              gains
            
            Gross
              unrealized
              losses
            
            Estimated
              market
              valueDecember
                31, 2007:FHLMC
                PCs, maturing during 2013
            
            $
            1,291,762
            
            $
            -
            
            $
            (20,591
            )
            $
            1,271,171December
                31, 2006:FHLMC
                PCs, maturing during 2013
            
            $
            1,662,540
            
            $
            -
            
            $
            (99,487
            )
            $
            1,563,053





The
      following tables present mortgage-backed securities unrealized losses and fair
      values, aggregated by length of time that individual securities have been in
      a
      continuous unrealized loss position, at December 31, 2007 and 2006. The current
      year unrealized losses on these investment securities are a result of volatility
      in the market during 2007 and relate to eleven FHLMC participation certificates.
      All unrealized losses on FHLMC participation certificates are considered by
      management to be temporary given the credit ratings on these investment
      securities.





2007Less
                Than 12 Months
            
            12
                Months or More
            
            TotalFair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              lossesSecurities
                available for sale:FHLMC
                PCs
            
            $
            1,418,557
            
            $
            (2,900
            )
            $
            18,997,231
            
            $
            (300,393
            )
            $
            20,415,788
            
            $
            (303,293
            )Securities
                held for investment:FHLMC
                PCs
            
            $
            -
            
            $
            -
            
            $
            1,271,172
            
            $
            (20,591
            )
            $
            1,271,172
            
            $
            (20,591
            )




2006Less
                Than 12 Months
            
            12
                Months or More
            
            TotalFair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              lossesSecurities
                available for sale:FHLMC
                PCs
            
            $
            8,598,800
            
            $
            (81,158
            )
            $
            14,955,333
            
            $
            (519,768
            )
            $
            23,554,133
            
            $
            (600,926
            )Securities
                held for investment:FHLMC
                PCs
            
            $
            -
            
            $
            -
            
            $
            1,563,053
            
            $
            (99,487
            )
            $
            1,563,053
            
            $
            (99,487
            )





28





**3.
      MORTGAGE-BACKED SECURITIES (Continued)**





Mortgage-backed
      securities, classified as available for sale or held for investment, at December
      31, 2007 are contractually scheduled to mature as follows:


Amortized
              cost
            
            Estimated
              market
              valueDue
                one year or less
            
            $
            15,432
            
            $
            15,572Due
                after one year through five years
            
            
            260,137
            
            
            268,470Due
                after five years through ten years
            
            
            3,486,250
            
            
            3,525,569Due
                after ten years
            
            
            35,355,822
            
            
            35,289,624Total
            
            $
            39,117,641
            
            $
            39,099,235





Expected
      maturities may differ from contractual maturities because borrowers have the
      right to call or prepay obligations with or without call or prepayment
      penalties. No mortgage-backed securities were sold in 2007 or 2006.
      Mortgage-backed securities with an amortized cost of $446,918 and $307,474
      were
      pledged as collateral for treasury tax and loan deposits at December 31, 2007
      and 2006, respectively.





**4.
      LOANS RECEIVABLE**





Loans
      receivable at December 31, 2007 and 2006 are summarized as follows:





2007
            
            2006Mortgage
                loans
            
            $
            51,189,747
            
            $
            74,690,012Consumer
                loans
            
            
            101,693,778
            
            
            103,785,611Commercial
                loans
            
            
            609,970,239
            
            
            580,902,157Leasing
            
            
            13,101,150
            
            
            12,640,043Total
            
            
            775,954,914
            
            
            772,017,823Less:
                Allowance for loan losses
            
            
            (9,486,479
            )
            
            (9,157,597
            )Deferred loan fees, net
            
            
            (1,385,530
            )
            
            (1,423,177
            )Loans
                receivable, net
            
            $
            765,082,905
            
            $
            761,437,049




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





During
      the years ended December 31, 2007, 2006, and 2005 the Bank exchanged loans
      with
      outstanding principal balances of $6,873,490, $17,203,225 and $16,354,875,
      respectively, with the Federal Home Loan Mortgage Corporation ("FHLMC") for
      mortgage-backed securities of equal value.





The
      Bank
      originates mortgage loans for portfolio investment or sale in the secondary
      market. During the period of origination, mortgage loans are designated as
      either held for sale or for investment purposes. Transfers of loans held for
      sale to the investment portfolio are recorded at the lower of cost or market
      value on the transfer date. Loans receivable held for sale at December 31,
      2007
      and 2006 are fixed rate mortgage loans with an estimated market value of
      approximately $7,752,968 and $25,963,341, respectively.





Net
      gains
      on sales of loans receivable held for sale amounted to $519,361, $329,743 and
      $199,414 for the years ended December 31, 2007, 2006 and 2005, respectively.





29





**4.
      LOANS RECEIVABLE (Continued)**





Activity
      in the allowance for credit losses, which includes the allowance for loan and
      lease losses and unfunded commitments for the years ended December 31, 2007,
      2006 and 2005, is summarized as follows:





Allowance - Loan
              and
                Lease Losses
            
            Allowance - Unfunded
              Commitments
            
            Allowance
                -
              Credit
                LossesBalance
                at December 31, 2004
            
            $
            8,343,382
            
            $
            —
            
            $
            8,343,382Provisions
                for credit losses
            
            
            602,308
            
            
            1,108,889
            
            
            1,711,197Loans
                charged off
            
            
            (845,228
            )
            
            —
            
            
            (845,228
            )Recoveries
            
            
            12,954
            
            
            —
            
            
            12,954Balance
                at December 31, 2005
            
            
            8,113,416
            
            
            1,108,889
            
            
            9,922,305Provisions
                for credit losses
            
            
            1,276,827
            
            
            (343,949
            )
            
            932,878Loans
                charged off
            
            
            (342,094
            )
            
            —
            
            
            (342,094
            )Recoveries
            
            
            109,448
            
            
            —
            
            
            109,448Balance
                at December 31, 2006
            
            
            9,157,597
            
            
            764,940
            
            
            9,922,537Provisions
                for credit losses
            
            
            712,297
            
            
            (362,297
            )
            
            350,000Loans
                charged off
            
            
            (420,717
            )
            
            —
            
            
            (420,717
            )Recoveries
            
            
            37,302
            
            
            —
            
            
            37,302Balance
                at December 31, 2007
            
            $
            9,486,479
            
            $
            402,643
            
            $
            9,889,122




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





December
                31,2007
            
            2006Loans
                  contractually past due over 90 days and/oron
                  nonaccrual status:Mortgage
                residential
            
            $
            798,072
            
            $
            934,022Consumer
                and commercial
            
            
            6,757,386
            
            
            1,806,353Total
            
            $
            7,555,458
            
            $
            2,740,375





For
      the
      years ended December 31, 2007, 2006 and 2005, interest income of approximately
      $505,990, $143,407 and $143,189, respectively, was not recorded related to
      loans
      accounted for on a nonaccrual basis.





**5.
      PREMISES AND EQUIPMENT**


Premises
        and equipment consist of the following:


December
                31,2007
            
            2006Land
            
            $
            3,102,730
            
            $
            2,809,449Office
                buildings and improvements
            
            
            7,481,953
            
            
            7,129,462Furniture,
                fixtures and equipment
            
            
            4,927,893
            
            
            4,507,943Vehicles
            
            
            479,797
            
            
            449,095Construction
                in process
            
            
            27,857
            
            
            33,68216,020,230
            
            
            14,929,631Less
                accumulated depreciation
            
            
            6,586,831
            
            
            6,031,622Total
            
            $
            9,433,399
            
            $
            8,898,009




The
      Company leases certain branch facilities and equipment under separate agreements
      that expire at various dates through January 31, 2013. Future rentals under
      these leases are as follows:




2008
            
            $
            536,9062009
            
            
            317,6122010
            
            
            181,3172011
            
            
            74,0422012
            
            
            60,751Thereafter
            
            
            2,305Total
            
            $
            1,172,933





30





**5.
      PREMISES AND EQUIPMENT (Continued)**





Rental
      expense amounting to approximately $541,180, $444,412 and $395,919 during the
      years ended December 31, 2007, 2006 and 2005, respectively, is included in
      premises and equipment expense on the accompanying consolidated statements
      of
      operations.





**6.
      DEPOSITS**





At
      December 31, 2007, the scheduled maturities of time deposits were as
      follows:





2008
            
            $
            484,633,7052009
            
            
            9,020,6072010
            
            
            3,385,6452011
            
            
            1,376,5262012
            
            
            1,807,731Thereafter
            
            
            -Total
                time deposits
            
            $
            500,224,214





**7.
      EMPLOYEE BENEFIT PLANS**





The
      Company participated in a multi-employer defined benefit pension plan which
      covered substantially all employees; however, effective January 31, 2002, the
      Company's Board of Directors approved a plan to freeze the accrual of future
      benefits under the plan. Consequently, no new employees became eligible to
      participate in the plan after January 31, 2002. Effective October 1, 2004,
      the
      Company withdrew from the plan. Active employees who were participating in
      the
      plan became 100% vested on that date and could select from a variety of benefit
      payment options based on their age and benefit payment amount. Expenses of
      the
      plan for unfunded liability, withdrawal fees, administrative fees and PBGC
      premiums the years ended December 31, 2007, 2006 and 2005 were $0, $9,470 and
      $0, respectively.





The
      Company also participates in a defined contribution plan which covers
      substantially all employees. During the years ended December 31, 2007 and 2006,
      employees may contribute from 1% to 100% of compensation, subject to an annual
      maximum as determined by the Internal Revenue Code, which is an increase in
      the
      contribution of 1% to 15% of compensation allowed during the year ended December
      31, 2005. The Company makes matching contributions of 100% of employees'
      contributions up to 5% of the employees' salaries.





The
      plan
      provides that employees' contributions are 100% vested at all times and the
      Bank's contributions vest 25% for each year of service. The expenses related
      to
      the Company's contributions to this plan for the years ended December 31, 2007,
      2006 and 2005 were $293,475, $354,235 and $326,549, respectively.  Directors
      and certain officers participate in deferred compensation plans. These plans
      provide for fixed payments beginning at retirement, and are earned over service
      periods of up to ten years, and include provisions for deferral of current
      payments. The expense related to these plans during the years ended December
      31,
      2007, 2006 and 2005 was $449,464, $471,509 and $486,662, respectively. The
      plans
      include provisions for forfeitures of unvested portions of payments, and vesting
      in the event of death or disability. The total liability under this plan was
      $3,264,438 at December 31, 2007 and is included in other liabilities in the
      accompanying consolidated statements of financial condition.





**8.
      STOCK BASED COMPENSATION**





Effective
      January 1, 2006, the Company adopted SFAS No. 123 (revised 2004),
“Share-Based Payment,” (“SFAS No. 123R”), issued by the Financial
      Accounting Standards Board (“FASB”) in December 2004. SFAS No. 123R
      revises SFAS No. 123, “Accounting for Stock Based Compensation,” and
      supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”
(“APB 25”), and its related interpretations. SFAS No. 123R requires the
      cost of employee services received in exchange for an award of equity
      instruments to be recognized in the financial statements over the period the
      employee is required to perform the services in exchange for the award
      (presumptively the vesting period). SFAS No. 123R also requires measurement
      of the cost of employee services received in exchange for an award based on
      the
      grant date fair value of the award. SFAS No. 123R also amends SFAS
      No. 95, “Statement of Cash Flows,” requiring that excess tax benefits be
      reported as financing cash inflows, rather than as a reduction of taxes paid,
      which is included within operating cash flows. The Company adopted SFAS
      No. 123R using the modified prospective application as permitted under SFAS
      No. 123R.




31





**8.
      STOCK BASED COMPENSATION (Continued)**





Accordingly,
      prior period amounts were not restated. Under this application, the Company
      records compensation expense for all awards granted after the date of adoption
      and for the unvested portion of previously granted awards that were outstanding
      at the date of adoption. Prior to the adoption of SFAS No. 123R, the
      Company used the intrinsic value method as prescribed by APB 25, and recognized
      no compensation expense for options granted with exercise prices equal to the
      fair market value of the Company’s common stock on the date of grant.





The
      Company has one share-based compensation plan. On April 8, 1998, the
      Stockholders of the Company approved the First South Bancorp, Inc. 1997 Stock
      Option Plan (the "Plan"). The purpose of the Plan is to advance the interests
      of
      the Company through providing selected key employees and Directors of the Bank
      and the Company with the opportunity to purchase shares. At December 31, 2007,
      the Plan includes 255,919 granted unexercised shares and 967,652 shares
      available to be granted. The option price is required to be 100% of the stock's
      fair market value as defined, with an exception for any stockholder with more
      than a 10% ownership interest in the Company. The exercise price is required
      to
      be 110% of the stock's fair market value for these options holders. Vesting
      is
      determined on the date of the grant. Options have a 10-year life; however,
      there
      are additional limitations for stockholders with more than a 10% ownership
      interest in the Company. The Plan also has a change of control provision under
      which all options immediately vest if a change of control, as defined, occurs.





A
      summary
      of option activity under the Plan as of December 31, 2007 and 2006, and
      changes during the years then ended is presented below:





Year
                Ended December 31, 2007:
            
            Options
              Available
            
            Options
              Outstanding
            
            Price
            
            Aggregate
              Intrinsic
                ValueOutstanding
                at December 31, 2006
            
            
            988,277
            
            
            538,374
            
            $
            9.65Granted
            
            
            (28,750
            )
            
            28,750
            
            $
            24.39Forfeited
            
            
            8,125
            
            
            (8,125
            )
            $
            19.37Exercised
            
            
            -
            
            
            (303,080
            )
            $
            7.19Outstanding
                at December 31, 2007
            
            
            967,652
            
            
            255,919
            
            $
            13.90
            
            $
            2,120,393





Year
                Ended December 31, 2006:
            
            Options
              Available
            
            Options
              Outstanding
            
            Price
            
            Aggregate
              Intrinsic
                ValueOutstanding
                at December 31, 2005
            
            
            1,003,977
            
            
            1,055,653
            
            $
            7.34Granted
            
            
            (20,500
            )
            
            20,500
            
            $
            29.22Forfeited
            
            
            4,800
            
            
            (4,800
            )
            $
            19.31Exercised
            
            
            -
            
            
            (532,979
            )
            $
            5.74Outstanding
                at December 31, 2006
            
            
            988,277
            
            
            538,374
            
            $
            9.65
            
            $
            11,975,810





The
      amount of cash received and value of shares tendered for payment of option
      exercises for the years ended December 31, 2007 and 2006 was $2,178,267 and
      $3,058,144, respectively.





The
      tax
      benefits realized for the tax credits from option exercises of the share-based
      payment arrangements were $2,430,435 and $3,965,214 for the years ended
      December 31, 2007 and 2006, respectively.





The
      intrinsic value of options exercised during the years ended December 31, 2007
      and 2006 was $7,083,625 and $11,309,095, respectively .




A
      summary
      of nonvested option shares as of December 31, 2007 and 2006, and changes
      during the years ended December 31, 2007 and 2006 is presented below:




December
                31, 2007
            
            December
                31, 2006Year
                Ended:
            
            Shares
            
            Price
            
            Shares
            
            PriceNonvested
                at beginning of year
            
            
            53,250
            
            $
            22.89
            
            
            75,300
            
            $
            18.22Granted
            
            
            28,750
            
            $
            24.39
            
            
            20,500
            
            $
            29.22Forfeited
            
            
            (3,250
            )
            $
            24.97
            
            
            (4,800
            )
            $
            19.31Vested
            
            
            (24,775
            )
            $
            21.11
            
            
            (37,750
            )
            $
            12.97Nonvested
                at end of year
            
            
            53,975
            
            $
            24.38
            
            
            53,250
            
            $
            22.89





32





**8.
      STOCK BASED COMPENSATION (Continued)**





The
      weighted-average fair value per share of options granted during the years ended
      December 31, 2007 and 2006 was $3.70 and $6.03, respectively. The fair value
      of
      each option grant is estimated on the date of grant using the Black Scholes
      Option Pricing Model, with the following weighted average assumptions used
      for
      grants during the years ended December 31, 2007, 2006 and 2005:


December
                31,Year
                Ended:
            
            2007
            
            2006
            
            2005Dividend
                growth rate
            
            
            17
            %
            
            17
            %
            
            17
            %Expected
                volatility
            
            
            22.6
            %
            
            22.3
            %
            
            21.4
            %Average
                risk-free interest rates
            
            
            3.7%
                to 4.6
            %
            
            4.7%
                to 5.1
            %
            
            4.0%
                to 4.5
            %Expected
                lives
            
            
            6
                years
            
            
            6
                years
            
            
            6
                years




The
      following table summarizes additional information about the Company’s
      outstanding options and exercisable options as of December 31, 2007, including
      weighted-average remaining contractual term expressed in years ("Life") and
      weighted average exercise price (“Price”):





Outstanding
            
            ExercisableRange
                of Exercise Price
            
            Shares
            
            Life
            
            Price
            
            Shares
            
            Price$5.41
                - 5.50
            
            
            84,124
            
            
            .34
            
            $
            5.41
            
            
            84,124
            
            $
            5.41$6.87
                - 10.37
            
            
            36,908
            
            
            3.44
            
            $
            8.39
            
            
            36,908
            
            $
            8.39$14.97
                - 16.61
            
            
            44,437
            
            
            5.19
            
            $
            16.19
            
            
            44,437
            
            $
            16.19$16.77
                - 25.22
            
            
            66,700
            
            
            8.16
            
            $
            20.55
            
            
            31,825
            
            $
            19.42$26.17
                - 33.30
            
            
            23,750
            
            
            8.75
            
            $
            29.62
            
            
            4,650
            
            $
            15.73255,919
            
            
            2.82
            
            $
            13.90
            
            
            201,944
            
            $
            10.77





The
      fair
      value compensation cost recognition provisions of SFAS 123R are different from
      the recognition provisions under SFAS 123 and the intrinsic value method for
      compensation cost allowed under APB 25. The following table reflects the impact
      of adopting SFAS 123R by reducing income before income taxes, net income, basic
      earnings per share and diluted earnings per share for the years ended December
      31, 2007 and 2006:




Year
                Ended December 31,2007
            
            2006Reduced
                net income before income taxes
            
            $
            83,764
            
            $
            126,450Reduced
                net income
            
            $
            76,843
            
            $
            115,038Reduced
                basic earnings per share
            
            $
            .01
            
            $
            .01Reduced
                diluted earnings per share
            
            $
            .00
            
            $
            .01





As
      of
      December 31, 2007 and 2006, there was $167,665 and $174,614, respectively,
      of total unrecognized compensation cost related to nonvested share-based
      compensation arrangements granted under the Plan. The unrecognized compensation
      cost as of December 31, 2007 is expected to be recognized the next four years.





The
      following table illustrates the effect on net income available to common
      stockholders if the Company had applied the fair value recognition provisions
      of
      SFAS No. 123 to the year ended December 31, 2005, using the Black Scholes
      Pricing Model assumptions listed above:




Year
                  Ended December 31, 2005As
                  Reported
              
              Pro
                  FormaNet
                  income - common stockholders
              
              $
              14,128,704
              
              $
              14,007,413Stock
                  based compensation, net of tax effect
              
              $
              -
              
              $
              121,291Net
                  income per share –
                  basic
              
              $
              1.49
              
              $
              1.47Net
                  income per share – diluted
              
              $
              1.41
              
              $
              1.41





33





**9.
      BORROWED MONEY**





Borrowed
      money represents advances from the FHLB and repurchase agreements. Advances
      outstanding from the FHLB at December 31, 2007 and 2006 had a weighted average
      rate of 4.40% and 5.50%, respectively, and totaled $35,000,000 and $6,000,000,
      respectively. These advances have a scheduled maturity date of January 3,
      2009.





At
      December 31, 2007 and December 31, 2006, repurchase agreements outstanding
      had
      average rates of 3.38% and 4.69%, respectively, and totaled $7,067,421 and
      $5,139,947, respectively.





At
      December 31, 2007 and 2006, repurchase agreements were collateralized by U.S.
      government agency obligations with a principal balance of $10,000,000. The
      Company has pledged all of its stock in the FHLB and certain loans secured
      by
      one to four family residential mortgages as collateral for actual or potential
      borrowings from the FHLB. At December 31, 2007 and 2006, the Company had
      approximately $146.0 million and $175.7 million, respectively, of additional
      credit available with the FHLB.





**10.
      INCOME TAXES**





The
      components of income tax expense for the years ended December 31, 2007, 2006
      and
      2005 are as follows:





Years
                Ended December 31,2007
            
            2006
            
            2005CurrentFederal
            
            $
            9,804,043
            
            $
            9,378,947
            
            $
            7,925,068State
            
            
            1,474,554
            
            
            1,894,604
            
            
            1,568,26911,278,597
            
            
            11,273,551
            
            
            9,493,337DeferredFederal
            
            
            (361,087
            )
            
            (165,994
            )
            
            (496,214
            )State
            
            
            (77,773
            )
            
            (35,753
            )
            
            (49,927
            )(438,860
            )
            
            (201,747
            )
            
            (546,141
            )Total
            
            $
            10,839,737
            
            $
            11,071,804
            
            $
            8,947,196





Reconciliations
      of the expected income tax expense at statutory tax rates with income tax
      expense reported in the statements of operations for the years ended December
      31, 2007, 2006 and 2005 are as follows:





Years
                Ended December 31,2007
            
            2006
            
            2005Expected
                income tax expense at 35%
            
            $
            9,745,037
            
            $
            9,892,456
            
            $
            8,076,565State
                  income taxes, net of federalincome
                  tax
            
            
            907,908
            
            
            1,208,253
            
            
            986,922Other
                expenses and adjustments
            
            
            186,792
            
            
            (28,905
            )
            
            (116,291
            )Total
            
            $
            10,839,737
            
            $
            11,071,804
            
            $
            8,947,196





The
      components of deferred income tax assets and liabilities are as follows:





Years
                Ended December 31,2007
            
            2006Deferred
                income tax assetsDeferred
                directors' fees
            
            $
            564,064
            
            $
            562,648Allowance
                for credit losses
            
            
            3,807,455
            
            
            3,820,651Employee
                benefits
            
            
            725,388
            
            
            771,798Loans
                mark-to-market
            
            
            166,214
            
            
            152,968Unrealized
                losses on securities available for sale
            
            
            -
            
            
            363,433Other
            
            
            218,200
            
            
            57,8625,481,321
            
            
            5,729,360





34





**10.
      INCOME TAXES (Continued)**





Deferred
                income tax liabilitiesDepreciation
                and amortization
            
            
            3,152,318
            
            
            3,483,047Carrying
                value –
                land
            
            
            395,000
            
            
            395,000Mortgage
                servicing rights
            
            
            454,493
            
            
            500,279Deferred
                loan origination fees and costs
            
            
            929,924
            
            
            807,690FHLB
                stock
            
            
            65,346
            
            
            141,451Unrealized
                gain on securities available for sale
            
            
            245,817
            
            
            -5,242,898
            
            
            5,327,467Net
                deferred income tax asset
            
            $
            238,423
            
            $
            401,893





**11.
      REGULATORY CAPITAL REQUIREMENTS**





Dividend
      payments made by the Company are subject to regulatory restrictions under
      Federal Reserve Board policy as well as to limitations under applicable
      provisions of Virginia corporate law. The Federal Reserve Board may prohibit
      a
      bank holding company from paying any dividends if the holding company's bank
      subsidiary is classified as "undercapitalized." Under Virginia law, dividends
      may be paid out of surplus or, if there is no surplus, out of net profits for
      the fiscal year in which the dividend is declared and for the preceding fiscal
      year. Furthermore, under FDIC regulations, the Bank is prohibited from making
      any capital distributions if, after making the distribution, the Bank would
      have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1
      risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less
      than 4.0%.





The
      Bank
      is subject to various regulatory capital requirements administered by the
      federal and state banking agencies. Failure to meet minimum capital requirements
      can initiate certain mandatory, and possibly additional discretionary, actions
      by regulators that, if undertaken, could have a direct material effect on the
      Bank's financial statements. Quantitative measures established by regulation
      to
      ensure capital adequacy require the Bank to maintain minimum amounts and ratios,
      as set forth in the table below. Management believes, as of December 31, 2007,
      that the Bank meets all capital adequacy requirements to which it is subject.
      The Company’s most significant asset is its investment in First South Bank.
      Consequently, the information concerning capital ratios is essentially the
      same
      for the Company and the Bank.





As
      of
      December 31, 2007, the most recent notification from the FDIC categorized the
      Bank as well capitalized under the regulatory framework for prompt corrective
      action. To be categorized as well capitalized the Bank must maintain minimum
      amounts and ratios, as set forth in the table below. There are no conditions
      or
      events since that notification that management believes have changed the Bank's
      category.





The
      Bank's actual regulatory capital amounts and ratios as of December 31, 2007
      and
      2006 are presented in the table below (dollars in thousands):


Actual
            
            Minimum
                for Capital
              Adequacy
                Purposes
            
            Minimum
                to be Well
              Capitalized
                under
              Prompt
                Corrective
              Action
                ProvisionsAmount
            
            Ratio
            
            Amount
            
            Ratio
            
            Amount
            
            RatioDecember
                31, 2007:Total
                Capital (to Risk Weighted Assets)
            $
            89,880
            
            
            12.2
            %
            $
            59,142
            
            
            8.0
            %
            $
            73,927
            
            
            10.0
            %Tier
                I Capital (to Risk Weighted Assets)
            
            80,631
            
            
            10.9
            %
            
            29,571
            
            
            4.0
            %
            
            44,356
            
            
            6.0
            %Tier
                I Capital (to Average Assets)
            
            80,631
            
            
            8.9
            %
            
            36,163
            
            
            4.0
            %
            
            45,204
            
            
            5.0
            %December
                31, 2006:Total
                Capital (to Risk Weighted Assets)
            $
            86,444
            
            
            11.7
            %
            $
            58,943
            
            
            8.0
            %
            $
            73,678
            
            
            10.0
            %Tier
                I Capital (to Risk Weighted Assets)
            
            77,225
            
            
            10.5
            %
            
            29,471
            
            
            4.0
            %
            
            44,207
            
            
            6.0
            %Tier
                I Capital (to Average Assets)
            
            77,225
            
            
            8.5
            %
            
            36,154
            
            
            4.0
            %
            
            45,193
            
            
            5.0
            %





35




**12.
      EARNINGS PER SHARE**





The
      following table provides a reconciliation of income available to common
      stockholders and the average number of shares outstanding (less unearned
      deferred stock awards and treasury shares) for the years ended December 31,
      2007, 2006 and 2005. Options to purchase 255,919, 538,374 and 1,055,653 shares
      of common stock were outstanding at December 31, 2007, 2006, and 2005,
      respectively.





Years
                Ended December 31,2007
            
            2006
            
            2005Net
                income (numerator)
            
            $
            17,003,227
            
            $
            17,192,356
            
            $
            14,128,704Weighted
                  average shares outstandingfor basic EPS
                  (denominator)
            
            
            9,914,929
            
            
            9,714,565
            
            
            9,488,073Dilutive
                effect of stock options
            
            
            112,799
            
            
            288,304
            
            
            492,149Adjusted
                shares for diluted EPS
            
            
            10,027,728
            
            
            10,002,869
            
            
            9,980,222





For
      the
      years ended December 31, 2007 and 2006, there were 30,500 and 8,000,
      respectively, options that were antidilutive since the exercise price exceeded
      the average market price of the Company’s common stock for the year. These
      options have been omitted from the calculation of diluted earnings per share
      for
      2007.





**13.
       MORTGAGE BANKING ACTIVITIES**





Mortgage
      loans serviced for others are not included in the accompanying consolidated
      statements of financial condition. The unpaid principal balances of mortgage
      loans serviced for others were $254,671,000, $245,620,000 and $260,632,000
      at
      December 31, 2007, 2006, and 2005 respectively. Servicing loans for others
      generally consists of collecting mortgage payments, maintaining escrow accounts,
      disbursing payment to investors and foreclosure processing. Loan servicing
      income is recorded on the accrual basis and includes servicing fees from
      investors and certain charges collected from borrowers, such as late payment
      fees.





At
      December 31, 2007 and 2006, mortgage servicing rights reported in the
      consolidated statements of financial condition, net of amortization, were
      $1,150,616 and $1,266,530 respectively.





During
      the years ended December 31, 2007 and 2006 respectively, the Company recorded
      additional servicing assets of $247,154 and $208,468 as a result of sales of
      loans or mortgage-backed securities. Amortization of servicing assets during
      the
      years ended December 31, 2007, 2006, and 2005 aggregated $363,068, $344,023,
      and
      $372,559, respectively. The fair value of recognized servicing assets amounted
      to approximately $2,785,000 and $2,300,000 as of December 31, 2007 and 2006,
      respectively. The Company's significant assumptions used to estimate their
      fair
      value include weighted average life, prepayment speeds, and expected costs
      to
      transfer servicing to a third party.





**14. 
      FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP**


**CONCENTRATION
      OF CREDIT RISK**





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





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





Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of any condition established in the contract. Commitments generally
      have fixed expiration dates or other termination clauses and may require payment
      of a fee. The Company evaluates each customer's creditworthiness on a
      case-by-case basis. The amount of collateral obtained, if deemed necessary
      by
      the Company upon extension of credit, is based on management's credit evaluation
      of the borrower.





36





**14. 
      FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP**


**CONCENTRATION
      OF CREDIT RISK (Continued)**





A
      summary
      of the contractual amounts of the Company's exposure to off-balance sheet risk
      as of December 31, 2007 and 2006 is as follows:





December
                31,2007
            
            2006Commitments
                to extend credit
            
            $
            122,786,000
            
            $
            98,085,000Undrawn
                  balances on lines of credit and undrawnbalances on credit reserves
                  (overdraft protection)
            
            
            53,565,000
            
            
            54,345,000Standby
                letters of credit
            
            
            1,416,000
            
            
            2,720,000Total
            
            $
            177,767,000
            
            $
            155,150,000





Included
      in the commitments to originate loans as of December 31, 2007 and December
      31,
      2006, are fixed interest rate loan commitments of approximately $13.6 million
      and $16.0 million, respectively. The shorter duration of interest-sensitive
      liabilities, to the extent they are used to fund these fixed-rate loans,
      indicates that the Company is exposed to interest rate risk because, in a rising
      rate environment, liabilities will be repricing faster at higher interest rates,
      thereby reducing the market value of fixed-rate long-term assets and net
      interest income.





The
      Company's lending is concentrated primarily in Beaufort, Craven, Cumberland,
      Dare, Edgecombe, Lenoir, Durham, Nash, Pasquotank, Pitt, Robeson, Wake,
      Currituck, and surrounding counties in North Carolina. Credit has been extended
      to certain of the Company's customers through multiple lending transactions.





Since
      many of the commitments are expected to expire without being drawn upon, amounts
      reported do not necessarily represent future cash requirements.





**15.
      PARENT COMPANY FINANCIAL INFORMATION**





The
      Company's principal asset is its investment in the Bank. Condensed financial
      statements of the parent company as of December 31, 2007, 2006 and 2005 are
      as
      follows:





Years
                Ended December 31,2007
            
            2006
            
            2005CONDENSED
                BALANCE SHEETSCash
            
            $
            1,961,421
            
            $
            1,673,729
            
            $
            1,307,746Investment
                in wholly-owned subsidiary
            
            
            85,509,789
            
            
            81,093,299
            
            
            75,530,645Other
                assets
            
            
            10,737,756
            
            
            8,003,533
            
            
            2,929,991Total
                assets
            
            $
            98,208,966
            
            $
            90,770,561
            
            $
            79,768,382Junior
                subordinated debentures
            
            $
            10,310,000
            
            $
            10,310,000
            
            $
            10,310,000Other
                liabilities
            
            
            1,863,644
            
            
            1,663,983
            
            
            1,267,910Stockholders'
                equity
            
            
            86,035,322
            
            
            78,796,578
            
            
            68,190,472Total
                liabilities and stockholders' equity
            
            $
            98,208,966
            
            $
            90,770,561
            
            $
            79,768,382CONDENSED
                STATEMENTS OF INCOMEInterest
                on junior subordinated debentures
            
            $
            839,110
            
            $
            815,331
            
            $
            632,629Equity
                in earnings of subsidiary
            
            
            17,660,805
            
            
            17,846,544
            
            
            14,597,194Miscellaneous
                income
            
            
            181,532
            
            
            161,143
            
            
            164,139Net
                income
            
            $
            17,003,227
            
            $
            17,192,356
            
            $
            14,128,704




37




**15.
      PARENT COMPANY FINANCIAL INFORMATION (Continued)**





CONDENSED
                STATEMENTS OF CASH FLOWSOperating
                activities:Net
                income
            
            $
            17,003,227
            
            $
            17,192,356
            
            $
            14,128,704Adjustments
                to reconcile net incometo
                net cash provided by operating activities:Amortization
                of intangibles
            
            
            24,996
            
            
            24,996
            
            
            24,996Equity
                in undistributed earnings of subsidiary
            
            
            (17,660,805
            )
            
            (17,846,544
            )
            
            (14,597,194
            )Other
                operating activities
            
            
            (2,674,648
            )
            
            (8,146,306
            )
            
            (1,023,368
            )Net
                cash provided used in operating activities
            
            
            (8,775,498
            )
            
            (8,775,498
            )
            
            (1,466,862
            )Investing
                activities:Payments
                for investments in and advances to subsidiary
            
            
            -
            
            
            -
            
            
            -Repayments
                of advances to subsidiary
            
            
            -
            
            
            -
            
            
            -Upstream
                dividend received from First South Bank
            
            
            14,200,140
            
            
            15,115,171
            
            
            5,895,276Net
                cash provided by investing activities
            
            
            14,200,140
            
            
            15,115,171
            
            
            5,895,276Financing
                activities:Proceeds
                from exercise of stock options
            
            
            3,459,780
            
            
            1,093,576
            
            
            1,012,468Purchase
                of treasury shares
            
            
            (6,722,276
            )
            
            (867,905
            )
            
            (336,726
            )Cash
                paid for dividends and fractional shares
            
            
            (7,342,722
            )
            
            (6,199,361
            )
            
            (4,867,849
            )Net
                cash used in financing activities
            
            
            (10,605,218
            )
            
            (5,973,690
            )
            
            (4,192,107
            )Net
                increase in cash
            
            
            287,692
            
            
            365,983
            
            
            236,307Cash
                at beginning of year
            
            
            1,673,729
            
            
            1,307,746
            
            
            1,071,439Cash
                at end of year
            
            $
            1,961,421
            
            $
            1,673,729
            
            $
            1,307,746





**16.
      QUARTERLY FINANCIAL DATA (UNAUDITED)**





Summarized
      unaudited quarterly financial data for the years ended December 31, 2007 and
      2006 is as follows (in thousands):




Fourth
            
            Third
            
            Second
            
            First2007:Interest
                income
            
            $
            17,591
            
            $
            17,639
            
            $
            17,525
            
            $
            17,322Interest
                expense
            
            
            7,309
            
            
            7,295
            
            
            7,286
            
            
            7,220Provision
                for credit losses
            
            
            150
            
            
            100
            
            
            100
            
            
            -Noninterest
                income
            
            
            2,726
            
            
            2,544
            
            
            2,382
            
            
            2,484Noninterest
                expense
            
            
            6,084
            
            
            5,816
            
            
            5,489
            
            
            5,521Income
                tax expense
            
            
            2,638
            
            
            2,714
            
            
            2,721
            
            
            2,767Net
                income
            
            $
            4,136
            
            $
            4,258
            
            $
            4,311
            
            $
            4,298Net
                income per common shareBasic
            
            $
            .42
            
            $
            .43
            
            $
            .43
            
            $
            .43Diluted
            
            $
            .42
            
            $
            .42
            
            $
            .43
            
            $
            .43Fourth
            
            
            Third
            
            
            Second
            
            
            First2006:Interest
                income
            
            $
            17,849
            
            $
            17,528
            
            $
            16,794
            
            $
            15,581Interest
                expense
            
            
            7,343
            
            
            6,960
            
            
            6,082
            
            
            5,221Provision
                for credit losses
            
            
            -
            
            
            150
            
            
            437
            
            
            346Noninterest
                income
            
            
            2,190
            
            
            2,516
            
            
            2,311
            
            
            2,244Noninterest
                expense
            
            
            5,532
            
            
            5,758
            
            
            5,562
            
            
            5,358Income
                tax expense
            
            
            2,799
            
            
            2,859
            
            
            2,737
            
            
            2,677Net
                income
            
            $
            4,365
            
            $
            4,317
            
            $
            4,287
            
            $
            4,223Net
                income per common shareBasic
            
            $
            .45
            
            $
            .44
            
            $
            .44
            
            $
            .44Diluted
            
            $
            .43
            
            $
            .43
            
            $
            .43
            
            $
            .42




38




**17.
      FAIR VALUES OF FINANCIAL INSTRUMENTS**





Statement
      of Financial Accounting Standards No. 107, "Disclosures about Fair Value of
      Financial Instruments" ("SFAS No. 107"), requires the disclosure of estimated
      fair values for financial instruments. Quoted market prices, if available,
      are
      utilized as an estimate of the fair value of financial instruments. Because
      no
      quoted market prices exist for a significant part of the Company's financial
      instruments, the fair value of such instruments has been derived based on
      management's assumptions with respect to future economic conditions, the amount
      and timing of future cash flows and estimated discount rates with respect to
      future economic conditions, the amount and timing of future cash flows and
      estimated discount rates. Different assumptions could significantly affect
      these
      estimates. Accordingly, the net realizable value could be materially different
      from the estimates presented below. In addition, the estimates are only
      indicative of individual financial instruments' values and should not be
      considered an indication of the fair value of the Company taken as a whole.





Fair
      values have been estimated using data which management considers as the best
      available, and estimation methodologies deemed suitable for the pertinent
      category of financial instrument.





The
      estimation methodologies, resulting fair values, and recorded carrying amounts
      at December 31, 2007 and 2006 were as follows:





Cash
      and
      cash equivalents are by definition short-term and do not present any
      unanticipated credit issues. Therefore, the carrying amount is a reasonable
      estimate of fair value. The estimated fair values of investment securities
      and
      mortgage backed securities are provided in Notes 2 and 3 to the financial
      statements. These are based on quoted market prices, when available. If a quoted
      market price is not available, fair value is estimated using quoted market
      prices for similar securities.





The
      fair
      value of the net loan portfolio has been estimated using the present value
      of
      expected cash flows, discounted at an interest rate adjusted for servicing
      costs
      and giving consideration to estimated prepayment risk and credit loss factors,
      as follows:





December
                31, 2007
            
            December
                31, 2006Estimated
              fairvalue
            
            Carrying
              amount
            
            Estimated
              fair value
            
            Carrying
              amount1
                -
                4 family mortgages
            
            $
            50,990,827
            
            $
            50,460,903
            
            $
            74,623,870
            
            $
            73,891,745Consumer
            
            
            99,659,781
            
            
            100,387,148
            
            
            101,571,532
            
            
            102,448,552Non-residential
            
            
            614,234,854
            
            
            614,234,854
            
            
            585,096,751
            
            
            585,096,752Total
            
            $
            764,885,462
            
            $
            765,082,905
            
            $
            761,592,153
            
            $
            761,437,049


The
      fair
      value of deposit liabilities with no stated maturities has been estimated to
      equal the carrying amount (the amount payable on demand), totaling $261,145,369
      and $283,203,473 at December 31, 2007 and 2006, respectively. The fair value
      estimates for these products do not reflect the benefits that the Bank receives
      from the low-cost, long-term funding they provide. These benefits are considered
      significant.





The
      fair
      value of certificates of deposits and advances from the FHLB is estimated by
      discounting the future cash flows using the current rates offered for similar
      deposits and advances with the same remaining maturities. The carrying value
      and
      estimated fair values of certificates of deposit and FHLB advances at December
      31, 2007 and 2006 are as follows:





2007
            
            2006Certificates
                of depositsCarrying
                amount
            
            $
            500,224,214
            
            $
            516,985,008Estimated
                fair value
            
            
            503,194,844
            
            
            520,987,553Advances
                for Federal Home Loan Bank:Carrying
                amount
            
            $
            35,000,000
            
            $
            6,000,000Estimated
                fair value
            
            
            35,000,000
            
            
            6,000,000




39





**17.
      FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)**





The
      carrying amount of accrued interest receivable, FHLB stock, note receivable,
      junior subordinated debentures, accrued interest payable, and repurchase
      agreements approximates their fair value.





There
      is
      no material difference between the carrying amount and estimated fair value
      of
      off-balance sheet items totaling $177,767,000 and $155,150,000 at December
      31,
      2007 and 2006, respectively, which are primarily comprised of unfunded loan
      commitments.





The
      Company's remaining assets and liabilities are not considered financial
      instruments.





**18.
      SUPPLEMENTAL CASH FLOW INFORMATION**





Supplemental
      cash flow information for the years ended December 31, 2007, 2006 and 2005
      is as
      follows:





Year
                ended December 31,2007
            
            2006
            
            2005Real
                estate acquired in settlement of loans
            
            $
            1,594,724
            
            $
            1,051,764
            
            $
            793,184Exchange
                of loans for mortgage-backed securities
            
            
            6,873,490
            
            
            17,203,225
            
            
            16,354,875Cash
                paid for interest
            
            
            29,053,118
            
            
            25,572,320
            
            
            15,443,427Cash
                paid for income taxes
            
            
            8,705,060
            
            
            8,360,047
            
            
            9,272,923Dividends
                declared, not paid
            
            
            1,863,644
            
            
            1,663,983
            
            
            1,267,910





**19. 
      JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST** **AND
      CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST** **SECURITIES
      OF SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE COMPANY**





The
      Company has sponsored a trust, First South Preferred Trust I (the Trust), of
      which 100% of the common equity is owned by the Company. The Trust was formed
      for the purpose of issuing company-obligated preferred trust securities (the
      Preferred Trust Securities) to third-party investors and investing the proceeds
      from the sale of such Preferred Trust Securities solely in junior subordinated
      debt securities of the Company (the Debentures). The Debentures held by the
      Trust are the sole assets of the Trust. Distributions on the Preferred Trust
      Securities issued by the Trust are payable quarterly at a rate equal to the
      interest rate being earned by the Trust on the Debentures held by that Trust.
      The Preferred Trust Securities are subject to mandatory redemption, in whole
      or
      in part, upon repayment of the Debentures. The Company has entered into an
      agreement, which fully and unconditionally guarantees the Preferred Trust
      Securities subject to the terms of the guarantee. The Debentures held by the
      Trust are first redeemable, in whole or in part, by the Company on or after
      September 30, 2008.





In
      the
      fourth quarter of 2003, as a result of applying the provisions of FIN 46R,
      governing when an equity interest should be consolidated, the Company was
      required to deconsolidate the subsidiary Trust from its financial statements.
      The deconsolidation of the net assets and results of operations of the Trust
      had
      virtually no impact on the Company's financial statements or liquidity position
      since the Company continues to be obligated to repay the Debentures held by
      the
      Trust and guarantees repayment of the Preferred Trust Securities issued by
      the
      Trust. The consolidated debt obligation related to the Trust increased from
      $10
      million to $10.3 million upon deconsolidation with the difference representing
      the Company's common ownership interest in the Trust. Subject to certain
      limitations, the Junior Subordinated Debentures qualify as Tier I capital for
      the Company under Federal Reserve Board guidelines.





Consolidated
      debt obligations as of December 31, 2007 related to a subsidiary Trust holding
      solely Debentures of the Company follows:





LIBOR
                + 2.95% junior subordinated debentures owed to First South Preferred
                Trust I due September 26, 2033
            
            $
            10,000,000LIBOR
                + 2.95% junior subordinated debentures owed to First South Preferred
                Trust I due September 26, 2033
            
            
            310,000Total
                junior subordinated debentures owed to unconsolidated subsidiary
                trust
            
            $
            10,310,000




40




**20.
      RELATED PARTY TRANSACTIONS**





The
      Company had loans outstanding to executive officers, directors and their
      affiliated companies. Management believes that these loans are made and
      processed on the same basis as loans to non-related parties. An analysis of
      the
      activity with respect to such aggregate loans to related parties is as
      follows:





Balance
                at December 31, 2006
            
            $
            1,819,438New
                loans during the year
            
            
            80,000Repayments
                during the year
            
            
            (338,289
            )Balance
                at December 31, 2007
            
            $
            1,561,149





41




**BOARD
      OF DIRECTORS**





**Frederick
                N. Holscher**
            **Marshall
                T. Singleton**
            **Linley
                H. Gibbs, Jr.**
            **Frederick
                H. Howdy****Chairman**
            **Vice
                Chairman**
            Retired
            PresidentPartner
            Co-Owner
            Washington,
                NC
            Drs.
                Freshwater & Howdy, P.A.Rodman,
                Holscher, Francisco,
            B.
                E. Singleton & Sons
            
            Washington,
                NC&
                Peck, P.A.
            Washington,
                NCWashington,
                NC**Charles
                E. Parker, Jr.**
            **H.
                D. Reaves, Jr.**
            **Thomas
                A. Vann**Senior
                Vice President
            Former
                President and
            President
                andRobinson
                & Stith Insurance
            Chief
                Executive Officer
            Chief
                Executive OfficerNew
                Bern, NC
            Home
                Federal Savings & Loan
            First
                South BankFayetteville,
                NC
            Washington,
                NC




**EXECUTIVE
      OFFICERS**




**Thomas
                A. Vann**
            **Larry
                W. Mallard**
            **William
                L. Wall**
            **James
                W. Hoose, Jr.**President
                and
            Executive
                Vice President
            Executive
                Vice President
            Executive
                Vice PresidentChief
                Executive Officer
            Chief
                Operating Officer
            Chief
                Financial Officer and
            Chief
                Credit OfficerSecretary**Sherry
                L. Correll**
            **Paul
                S. Jaber**
            **Mary
                R. Boyd**
            **J.
                Randy Woodson**Executive
                Vice President
            Executive
                Vice President
            Executive
                Vice President
            Executive
                Vice PresidentBank
                Operations
            Mortgage
                Operations
            Loan
                Servicing
            Retail
                Banking**Kristie
                W. Hawkins**TreasurerController**AREA
                & SUBSIDIARY EXECUTIVES****Timothy
                M. Brown**
            **Dennis
                A. Nichols**
            **Donnie
                L.G. Bunn**Senior
                Vice President
            Senior
                Vice President
            PresidentArea
                Executive
            Area
                Executive
            First
                South Leasing, LLC.Cape
                Fear Region
            Neuse
                Region
            Greenville,
                NC**CITY
                & BRANCH EXECUTIVES**
            ********
            ****
            ******Jerry
                G. Hannah**
            **Joseph
                M. Johnson**
            **Thomas
                S. Lewis**
            **Kenneth
                W. Marshall, Jr.**Vice
                President
            Senior
                Vice President
            Vice
                President
            Assistant
                Vice PresidentCity
                Executive Kinston, NC
            City
                Executive Durham, NC
            City
                Executive Rocky Mount, NC
            City
                Executive Buxton, NC**Rhonda
                B. McLeod**
            **Robert
                C. Pfeiffer**
            **Donald
                B. Strickland, Jr.**
            **William
                P. Stone**Assistant
                Vice President
            Senior
                Vice President
            Senior
                Vice President
            Vice
                PresidentCity
                Executive Hope Mills, NC
            City
                Executive Elizabeth City, NC
            City
                Executive Greenville, NC
            City
                Executive Lumberton, NC**Clyle
                F. Swanner, Jr.**
            **George
                R. Hamilton**
            **Renee
                P. Richardson**Vice
                President
            Senior
                Vice President
            Vice
                PresidentCity
                Executive Washington, NC
            Branch
                Executive Rocky Mount, NC
            City
                Executive Fayetteville, NC




42




**FIRST
                SOUTH BANK OFFICE LOCATIONS********Buxton**
            **Hope
                Mills**
            1378
                Benvenue Road47560
                NC Highway 12
            3103
                North Main Street
            Rocky
                Mount, NC 27804Buxton,
                NC 27920
            Hope
                Mills, NC 28348
            (252)
                442-8375(252)
                995-3250
            (910)
                423-09523635
                North Halifax Road**Chocowinity**
            **Kill
                Devil Hills**
            Rocky
                Mount, NC 278042999
                Highway 17 South
            1906
                South Croatan Highway
            (252)
                451-8700Chocowinity,
                NC 27817
            Kill
                Devil Hills, NC 27948(252)
                940-4970
            (252)
                441-9935
            **Raleigh**4800
                Six Forks Road, Suite 115**Dunn**
            Island
                Land Centre
            Raleigh,
                NC 27609904-A
                West Broad Street
            3210
                North Croatan Highway
            (919)
                783-5222Dunn,
                NC 28334
            Kill
                Devil Hills, NC 27948(910)
                892-2861
            (252)
                441-8743
            **Tarboro**100
                East Hope Lodge Street**Durham**
            **Kinston**
            Tarboro,
                NC 278864215-01
                University Drive
            2430
                Herritage Street
            (252)
                823-0157Durham,
                NC 27707
            Kinston,
                NC 28503(919)
                403-1000
            (252)
                523-9449
            **Washington**1311
                Carolina Avenue**Elizabeth
                City**
            **Lumberton**
            Washington,
                NC 27889604
                East Ehringhaus Street
            600
                North Chestnut Street
            (252)
                946-4178Elizabeth
                City, NC 27906
            Lumberton,
                NC 28359(252)
                335-0848
            (910)
                739-3274
            300
                North Market StreetWashington,
                NC 27889**Fayetteville**
            3000
                North Elm Street
            (252)
                940-4945241
                Green Street
            Lumberton,
                NC 28359Fayetteville,
                NC 28302
            (910)
                608-5031
            1328
                John Small Avenue(910)
                483-3681
            
            Washington,
                NC 27889**New
                Bern**
            (252)
                940-5000705
                Executive Place
            202
                Craven StreetFayetteville,
                NC 28305
            New
                Bern, NC 28561
            **Operations
                Center and**(910)
                484-2116
            (252)
                636-2997
            **Credit
                Administration**220
                Creekside Drive**Grantsboro**
            1725
                Glenburnie Road
            Washington,
                NC 2788911560
                NC Highway 55, Suite 11
            New
                Bern, NC 28561
            (252)
                946-4178Grantsboro,
                NC 28529
              (252)
                745-5001
            (252)
                636-3569
              
              2019
                South Glenburnie Road
            **Loan
                Production Offices**
              3804
                Peachtree Avenue, Unit 200New
                Bern, NC 28561
            Wilmington,
                NC 28403**Greenville**
            (252)
                  637-1110
            (910)
                  798-6102301
                East Arlington BoulevardGreenville,
                NC 27835
            **Rocky
                Mount**
            3200
              Croasdaile Drive, Suite 703(252)
                321-2600
            300
                Sunset Avenue
            Durham,
                NC 27705907
                East Firetower Road
            Rocky
                  Mount, NC 27804
            (919)
                382-3295Greenville,
                NC 27835
              (252)
                355-4644
            (252)
                972-9661
            **First
                South Leasing**1707
                SE Greenville Boulevard
              Greenville,
                NC 27858
            2901
                Sunset Avenue
              Rocky
                Mount, NC 27804
              (252)
                451-1259
            1035
                Director Court, Unit C
              Greenville,
                NC 27858
              (252)
                355-4536(252)752-2770Member
                FDIC •Equal
                Housing Lender




43







**STOCKHOLDER
      INFORMATION**





**Corporate
      Headquarters**


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





**Stock
      Listing Information**


The
      Company's common stock is listed and trades on the NASDAQ Global Select Market
      under the symbol FSBK. As of March 3, 2008, there were 847 registered
      stockholders of record.





**Stock
      Price Information**


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





Quarter
                Ended
            
            High
            
            Low
            
            DividendsMarch
                31, 2007
            
            
            32.06
            
            
            25.35
            
            
            .19June
                30, 2007
            
            
            31.25
            
            
            26.50
            
            
            .19September
                30, 2007
            
            
            29.85
            
            
            24.42
            
            
            .19December
                31, 2007
            
            
            27.88
            
            
            22.01
            
            
            .19March
                31, 2006 (1)
            
            $
            25.33
            
            $
            22.70
            
            $
            .17June
                30, 2006 (1)
            
            
            34.72
            
            
            23.85
            
            
            .17September
                30, 2006
            
            
            34.72
            
            
            28.50
            
            
            .17December
                31, 2006
            
            
            33.60
            
            
            29.65
            
            
            .17





(1)
      Adjusted for three-for-two stock split on May 25, 2006.




**Registrar
      and Transfer Agent**


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





**Form
      10-K**


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





**Investor
      Information**


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





**Annual
      Meeting**


The
      Annual Meeting of Stockholders of First South Bancorp, Inc. will be held
      Thursday, May 22, 2008 at 11:00 a.m., at the main office of First South Bank,
      1311 Carolina Avenue, Washington, North Carolina.





**General
                Counsel**
            
            **Special
                Counsel**
            
            **Independent
                Accountants**Rodman, Holscher, Francisco & Peck, PA
            
            Muldoon Murphy & Aguggia LLP
            
            Turlington and Company, LLP320 North Market Street
            
            5101 Wisconsin Avenue, NW
            
            509 East Center StreetWashington, NC  27889
            
            Washington, DC 20016
            
            Lexington, NC 27293




44




**COMPARATIVE
      STOCK PERFORMANCE GRAPH**




The
      graph
      and table which follow show the cumulative total return on the Common Stock
      for
      the period from December 31, 2002 through December 31, 2007 with (1) the total
      cumulative return of all companies whose equity securities are traded on the
      Nasdaq Stock Market and (2) the total cumulative return of banking companies
      traded on the Nasdaq Stock Market. The comparison assumes $100 was invested
      on
      December 31, 2002 in the Company’s Common Stock and in each of the foregoing
      indices and assumes reinvestment of dividends. The stockholder returns shown
      on
      the performance graph are not necessarily indicative of the future performance
      of the Common Stock or of any particular index.









**12/31/02**
            
            **12/31/03**
            
            **12/31/04**
            
            **12/31/05**
            
            **12/31/06**
            
            **12/31/07**First
                South Bancorp Inc.
            
            $
            100.00
            
            $
            104.94
            
            $
            112.68
            
            $
            159.29
            
            $
            220.65
            
            $
            157.42NASDAQ
            
            $
            100.00
            
            $
            149.75
            
            $
            164.64
            
            $
            168.60
            
            $
            187.83
            
            $
            205.22NASDAQ
                Bank
            
            $
            100.00
            
            $
            130.51
            
            $
            144.96
            
            $
            141.92
            
            $
            159.42
            
            $
            125.80




45




*F* *irst* *S* *outh* *B* *ancorp*
 1311
        Carolina Avenue
 P.O.
        Box
        2047
 Washington,
        North Carolina 27889
 (252)
        946-4178 • Fax (252) 946-3873
 www.firstsouthnc.com