UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q


(Mark
One)


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





For the
quarterly period ended September 30, 2010.





OR


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


For the
transition period from  to .





Commission
File Number: 0-22219





FIRST SOUTH BANCORP,
INC.


(Exact
name of registrant as specified in its charter)





Virginia
                  
                  56-1999749(State
      or other jurisdiction of
                  
                  (IRS
      Employerincorporation
      or organization)
                  
                  Identification
      No.)





1311 Carolina Avenue,
Washington, North Carolina 27889


(Address
of principal executive offices)


(Zip
Code)





(252)
946-4178


(Registrant's
telephone number, including area code)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes  xNo  ̈





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





Large Accelerated Filer ̈
              Accelerated
      FilerxNon-Accelerated Filer ̈
              Smaller Reporting
      Company ̈(Do
      not check if a Smaller Reporting Company)





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





Number of
shares of common stock outstanding as of November 5, 2010:
9,751,271.








CONTENTS





PAGEPART
      I.  FINANCIAL
      INFORMATIONItem
      1.
                                              Financial
      StatementsConsolidated
      Statements of Financial Condition as of September 30, 2010(unaudited)
      and December 31, 2009
                                              
                                              
                                              1Consolidated
      Statements of Operations for the Three and Nine Months
    EndedSeptember
      30, 2010 and 2009 (unaudited)
                                              
                                              
                                              2Consolidated
      Statement of Stockholders' Equity for the Nine Months
EndedSeptember
      30, 2010 (unaudited)
                                              
                                              
                                              3Consolidated
      Statements of Cash Flows for the Nine Months EndedSeptember
      30, 2010 and 2009 (unaudited)
                                              
                                              
                                              4Notes
      to Consolidated Financial Statements (unaudited)
                                              
                                              
                                              5Item
      2.
                                              Management's
      Discussion and Analysis of Financial Condition andResults
      of Operation
                                              
                                              
                                              11Item
      3.
                                              Quantitative
      and Qualitative Disclosures About Market Risk
                                              
                                              
                                              20Item
      4.
                                              Controls
      and Procedures
                                              
                                              
                                              20PART
      II.  OTHER
      INFORMATIONItem
      1.
                                              Legal
      Proceedings
                                              
                                              
                                              21Item
      1A.
                                              Risk
      Factors
                                              
                                              
                                              21Item
      2.
                                              Unregistered
      Sales of Equity Securities and Use of Proceeds
                                              
                                              
                                              22Item
      3.
                                              Defaults
      Upon Senior Securities
                                              
                                              
                                              22Item
      4.
                                              [Reserved]
                                              
                                              
                                              22Item
      5.
                                              Other
      Information
                                              
                                              
                                              22Item
      6.
                                              Exhibits
                                              
                                              
                                              22Signatures
                                              
                                              
                                              23Exhibits





First
South Bancorp, Inc. and Subsidiary
 Consolidated
Statements of Financial Condition
 
 September 30,
                    
                    
                    December 31,2010
                    
                    
                    2009(unaudited)AssetsCash
      and due from banks
                    
                    $
                    16,331,418
                    
                    
                    $
                    17,758,370Interest-bearing
      deposits in financial institutions
                    
                    
                    24,483,235
                    
                    
                    
                    11,879,794Investment
      securities - available for sale
                    
                    
                    0
                    
                    
                    
                    407,317Mortgage-backed
      securities - available for sale
                    
                    
                    86,921,971
                    
                    
                    
                    96,725,468Mortgage-backed
      securities - held for investment
                    
                    
                    322,819
                    
                    
                    
                    513,882Loans
      and leases receivable, net:Held
      for sale
                    
                    
                    5,163,550
                    
                    
                    
                    6,548,980Held
      for investment
                    
                    
                    637,216,753
                    
                    
                    
                    652,106,538Premises
      and equipment, net
                    
                    
                    9,215,998
                    
                    
                    
                    8,539,759Other
      real estate owned
                    
                    
                    8,598,517
                    
                    
                    
                    10,561,071Federal
      Home Loan Bank of Atlanta stock, at cost which approximates
      market
                    
                    
                    3,610,700
                    
                    
                    
                    3,889,500Accrued
      interest receivable
                    
                    
                    2,981,970
                    
                    
                    
                    3,318,141Goodwill
                    
                    
                    4,218,576
                    
                    
                    
                    4,218,576Mortgage
      servicing rights
                    
                    
                    1,298,828
                    
                    
                    
                    1,278,688Identifiable
      intangible assets
                    
                    
                    110,040
                    
                    
                    
                    133,620Income
      tax receivable
                    
                    
                    1,956,063
                    
                    
                    
                    1,831,598Prepaid
      expenses and other assets
                    
                    
                    9,481,773
                    
                    
                    
                    10,179,333Total
      assets
                    
                    $
                    811,912,211
                    
                    
                    $
                    829,890,635Liabilities
      and Stockholders' EquityDeposits:Demand
                    
                    $
                    237,676,896
                    
                    
                    $
                    224,507,362Savings
                    
                    
                    24,946,121
                    
                    
                    
                    23,137,391Large
      denomination certificates of deposit
                    
                    
                    222,787,058
                    
                    
                    
                    224,198,974Other
      time
                    
                    
                    210,645,373
                    
                    
                    
                    216,667,331Total
      deposits
                    
                    
                    696,055,448
                    
                    
                    
                    688,511,058Borrowed
      money
                    
                    
                    12,164,166
                    
                    
                    
                    37,380,388Junior
      subordinated debentures
                    
                    
                    10,310,000
                    
                    
                    
                    10,310,000Other
      liabilities
                    
                    
                    6,089,267
                    
                    
                    
                    7,475,085Total
      liabilities
                    
                    
                    724,618,881
                    
                    
                    
                    743,676,531Common
      stock, $.01 par value, 25,000,000 shares authorized;11,254,222
      issued; 9,743,971 and 9,742,296shares
      outstanding, respectively
                    
                    
                    97,440
                    
                    
                    
                    97,423Additional
      paid-in capital
                    
                    
                    35,889,574
                    
                    
                    
                    35,841,364Retained
      earnings, substantially restricted
                    
                    
                    81,454,239
                    
                    
                    
                    82,111,114Treasury
      stock at cost
                    
                    
                    (32,122,465
                    )
                    
                    
                    (32,158,074
                    )Accumulated
      other comprehensive income, net
                    
                    
                    1,974,542
                    
                    
                    
                    322,277Total
      stockholders' equity
                    
                    
                    87,293,330
                    
                    
                    
                    86,214,104Total
      liabilities and stockholders' equity
                    
                    $
                    811,912,211
                    
                    
                    $
                    829,890,635
 
 *Derived
from audited consolidated financial statements
  See
Notes to Consolidated Financial Statements.
  1
 
 First
South Bancorp, Inc. and Subsidiary
 Consolidated
Statements of Operations
 (unaudited)
 Three Months Ended
                  
                  
                  Nine Months EndedSeptember 30
                  
                  
                  September 302010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Interest
      income:Interest
      and fees on loans
                  
                  $
                  9,970,388
                  
                  
                  $
                  11,162,577
                  
                  
                  $
                  29,872,142
                  
                  
                  $
                  34,428,527Interest
      and dividends on investments and deposits
                  
                  
                  992,276
                  
                  
                  
                  1,033,088
                  
                  
                  
                  3,070,839
                  
                  
                  
                  2,779,797Total
      interest income
                  
                  
                  10,962,664
                  
                  
                  
                  12,195,665
                  
                  
                  
                  32,942,981
                  
                  
                  
                  37,208,324Interest
      expense:Interest
      on deposits
                  
                  
                  2,050,824
                  
                  
                  
                  3,537,810
                  
                  
                  
                  6,298,950
                  
                  
                  
                  11,815,289Interest
      on borrowings
                  
                  
                  81,915
                  
                  
                  
                  293,355
                  
                  
                  
                  302,082
                  
                  
                  
                  974,106Interest
      on junior subordinated notes
                  
                  
                  89,021
                  
                  
                  
                  90,658
                  
                  
                  
                  251,805
                  
                  
                  
                  307,966Total
      interest expense
                  
                  
                  2,221,760
                  
                  
                  
                  3,921,823
                  
                  
                  
                  6,852,837
                  
                  
                  
                  13,097,361Net
      interest income
                  
                  
                  8,740,904
                  
                  
                  
                  8,273,842
                  
                  
                  
                  26,090,144
                  
                  
                  
                  24,110,963Provision
      for credit losses
                  
                  
                  3,961,787
                  
                  
                  
                  1,260,000
                  
                  
                  
                  8,451,787
                  
                  
                  
                  4,480,000Net
      interest income after provision for credit losses
                  
                  
                  4,779,117
                  
                  
                  
                  7,013,842
                  
                  
                  
                  17,638,357
                  
                  
                  
                  19,630,963Non-interest
      income:Fees
      and service charges
                  
                  
                  1,772,368
                  
                  
                  
                  1,835,435
                  
                  
                  
                  5,198,288
                  
                  
                  
                  5,477,372Loan
      servicing fees
                  
                  
                  188,292
                  
                  
                  
                  173,967
                  
                  
                  
                  555,072
                  
                  
                  
                  496,795Gain
      (loss) on sale of other real estate, net
                  
                  
                  39,858
                  
                  
                  
                  (86,875
                  )
                  
                  
                  73,578
                  
                  
                  
                  (161,323
                  )Gain
      on sale of mortgage loans
                  
                  
                  478,996
                  
                  
                  
                  247,189
                  
                  
                  
                  844,520
                  
                  
                  
                  935,291Gain
      on sale of mortgage-backed securities
                  
                  
                  696,410
                  
                  
                  
                  -
                  
                  
                  
                  1,631,891
                  
                  
                  
                  -Gain
      on sale of investment securities
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,406
                  
                  
                  
                  917,866Other  income
                  
                  
                  223,777
                  
                  
                  
                  231,313
                  
                  
                  
                  618,740
                  
                  
                  
                  768,081Total
      non-interest income
                  
                  
                  3,399,701
                  
                  
                  
                  2,401,029
                  
                  
                  
                  8,924,495
                  
                  
                  
                  8,434,082Non-interest
      expense:Compensation
      and fringe benefits
                  
                  
                  3,994,384
                  
                  
                  
                  3,524,025
                  
                  
                  
                  11,800,621
                  
                  
                  
                  10,523,200Federal
      deposit insurance premiums
                  
                  
                  285,040
                  
                  
                  
                  274,908
                  
                  
                  
                  868,918
                  
                  
                  
                  955,117Premises
      and equipment
                  
                  
                  417,751
                  
                  
                  
                  451,967
                  
                  
                  
                  1,315,500
                  
                  
                  
                  1,371,822Advertising
                  
                  
                  46,168
                  
                  
                  
                  37,155
                  
                  
                  
                  111,582
                  
                  
                  
                  100,171Payroll
      and other taxes
                  
                  
                  349,388
                  
                  
                  
                  330,426
                  
                  
                  
                  1,066,098
                  
                  
                  
                  1,017,520Data
      processing
                  
                  
                  636,299
                  
                  
                  
                  625,837
                  
                  
                  
                  1,899,367
                  
                  
                  
                  1,829,505Amortization
      of intangible assets
                  
                  
                  123,165
                  
                  
                  
                  122,003
                  
                  
                  
                  348,126
                  
                  
                  
                  371,334Other
                  
                  
                  893,270
                  
                  
                  
                  1,164,154
                  
                  
                  
                  2,576,365
                  
                  
                  
                  2,877,064Total
      non-interest expense
                  
                  
                  6,745,465
                  
                  
                  
                  6,530,475
                  
                  
                  
                  19,986,577
                  
                  
                  
                  19,045,733Income
      before income taxes
                  
                  
                  1,433,353
                  
                  
                  
                  2,884,396
                  
                  
                  
                  6,576,275
                  
                  
                  
                  9,019,312Income
      taxes
                  
                  
                  423,742
                  
                  
                  
                  1,122,727
                  
                  
                  
                  2,458,604
                  
                  
                  
                  3,493,246Net
      income
                  
                  $
                  1,009,611
                  
                  
                  $
                  1,761,669
                  
                  
                  $
                  4,117,671
                  
                  
                  $
                  5,526,066Per
      share data:Basic
      earnings per share
                  
                  $
                  0.10
                  
                  
                  $
                  0.18
                  
                  
                  $
                  0.42
                  
                  
                  $
                  0.57Diluted
      earnings per share
                  
                  $
                  0.10
                  
                  
                  $
                  0.18
                  
                  
                  $
                  0.42
                  
                  
                  $
                  0.57Dividends
      per share
                  
                  $
                  0.09
                  
                  
                  $
                  0.20
                  
                  
                  $
                  0.49
                  
                  
                  $
                  0.60Weighted
      average shares-Basic
                  
                  
                  9,743,971
                  
                  
                  
                  9,738,475
                  
                  
                  
                  9,743,490
                  
                  
                  
                  9,738,225Weighted
      average shares-Diluted
                  
                  
                  9,743,971
                  
                  
                  
                  9,738,550
                  
                  
                  
                  9,743,724
                  
                  
                  
                  9,738,250
 
 See
Notes to Consolidated Financial Statements.
  2
 
 First
South Bancorp, Inc. and Subsidiary
 Consolidated
Statements of Stockholders' Equity
 Nine
Months Ended September 30, 2010
 (unaudited)
 
 AccumulatedRetained
                  
                  
                  
                  
                  
                  OtherAdditional
                  
                  
                  Earnings,
                  
                  
                  
                  
                  
                  ComprehensiveCommon
                  
                  
                  Paid-in
                  
                  
                  Substantially
                  
                  
                  Treasury
                  
                  
                  Income,Stock
                  
                  
                  Capital
                  
                  
                  Restricted
                  
                  
                  Stock
                  
                  
                  Net
                  
                  
                  TotalBalance,
      December 31, 2009
                  
                  $
                  97,423
                  
                  
                  $
                  35,841,364
                  
                  
                  $
                  82,111,114
                  
                  
                  $
                  (32,158,074
                  )
                  
                  $
                  322,277
                  
                  
                  $
                  86,214,104Net
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4,117,671
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4,117,671Other
      comprehensive income, net of taxes
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,652,265
                  
                  
                  
                  1,652,265Exercise
      of stock options
                  
                  
                  17
                  
                  
                  
                  (26,414
                  )
                  
                  
                  
                  
                  
                  
                  35,609
                  
                  
                  
                  
                  
                  
                  
                  9,212Stock
      based compensation
                  
                  
                  
                  
                  
                  
                  74,624
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  74,624Dividends
      ($0.49 per share)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,774,546
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,774,546
                  )Balance,
      September 30, 2010
                  
                  $
                  97,440
                  
                  
                  $
                  35,889,574
                  
                  
                  $
                  81,454,239
                  
                  
                  $
                  (32,122,465
                  )
                  
                  $
                  1,974,542
                  
                  
                  $
                  87,293,330
 
 See
Notes to Consolidated Financial Statements.
  3
 
 First South Bancorp, Inc.
and Subsidiary
 Consolidated
Statements of Cash Flows
 (unaudited)
 
 Nine Months EndedSeptember 302010
                    
                    
                    2009Operating
      activities:Net
      income
                    
                    $
                    4,117,671
                    
                    
                    $
                    5,526,066Adjustments
      to reconcile net income to net cash used in operating
      activities:Provision
      for credit losses
                    
                    
                    8,451,787
                    
                    
                    
                    4,480,000Depreciation
                    
                    
                    555,542
                    
                    
                    
                    629,208Amortization
      of intangibles
                    
                    
                    348,126
                    
                    
                    
                    371,334Accretion
      of discounts on securities, net
                    
                    
                    -
                    
                    
                    
                    (64,113
                    )Loss
      (gain) on disposal of premises and equipment and other real estate
      owned
                    
                    
                    (76,874
                    )
                    
                    
                    160,752Gain
      on sale of loans held for sale
                    
                    
                    (844,520
                    )
                    
                    
                    (935,291
                    )Gain
      on sale of mortgage-backed securities available for sale
                    
                    
                    (1,631,891
                    )
                    
                    
                    -Gain
      on sale of investment securities available for sale
                    
                    
                    (2,406
                    )
                    
                    
                    (917,866
                    )Stock
      based compensation expense
                    
                    
                    74,624
                    
                    
                    
                    (45,880
                    )Originations
      of loans held for sale, net
                    
                    
                    (54,158,898
                    )
                    
                    
                    (88,262,687
                    )Proceeds
      from sale of loans held for sale
                    
                    
                    30,146,516
                    
                    
                    
                    25,403,227Other
      operating activities
                    
                    
                    574,620
                    
                    
                    
                    631,100Net
      cash used in operating activities
                    
                    
                    (12,445,703
                    )
                    
                    
                    (53,024,150
                    )Investing
      activities:Proceeds
      from maturity of investment securities available for sale
                    
                    
                    -
                    
                    
                    
                    15,000,000Proceeds
      from sale of investment securities available for sale
                    
                    
                    507,406
                    
                    
                    
                    20,917,866Proceeds
      from sale of mortgage-backed securities available for sale
                    
                    
                    33,044,077
                    
                    
                    
                    -Proceeds
      from principal repayments of mortgage-backed securities available for
      sale
                    
                    
                    7,266,976
                    
                    
                    
                    9,158,161Proceeds
      from principal repayments of mortgage-backed securities held for
      investment
                    
                    
                    191,063
                    
                    
                    
                    235,051Originations
      of loans held for investment, net of principal repayments
                    
                    
                    (596,353
                    )
                    
                    
                    46,760,172Proceeds
      from disposal of premises and equipment and other real estate
      owned
                    
                    
                    6,598,835
                    
                    
                    
                    6,881,783Purchase
      of investment securities
                    
                    
                    -
                    
                    
                    
                    (5,000,000
                    )Sale
      (purchase) of FHLB stock
                    
                    
                    278,800
                    
                    
                    
                    (230,900
                    )Purchase
      of premises and equipment
                    
                    
                    (1,231,781
                    )
                    
                    
                    (189,421
                    )Net
      cash provided by investing activities
                    
                    
                    46,059,023
                    
                    
                    
                    93,532,712Financing
      activities:Net
      increase (decrease) in deposit accounts
                    
                    
                    7,544,390
                    
                    
                    
                    (6,575,603
                    )Net
      decrease in FHLB borrowings
                    
                    
                    (25,000,000
                    )
                    
                    
                    (10,000,000
                    )Proceeds
      from exercise of stock options, net of tax benefit
                    
                    
                    9,212
                    
                    
                    
                    17,178Cash
      paid for dividends
                    
                    
                    (4,774,211
                    )
                    
                    
                    (5,842,858
                    )Net
      change in repurchase agreements
                    
                    
                    (216,222
                    )
                    
                    
                    (3,518,346
                    )Net
      cash used by financing activities
                    
                    
                    (22,436,831
                    )
                    
                    
                    (25,919,629
                    )Increase
      in cash and cash equivalents
                    
                    
                    11,176,489
                    
                    
                    
                    14,588,933Cash
      and cash equivalents, beginning of period
                    
                    
                    29,638,164
                    
                    
                    
                    26,720,359Cash
      and cash equivalents, end of period
                    
                    $
                    40,814,653
                    
                    
                    $
                    41,309,292Supplemental
      disclosures:Other
      real estate acquired in settlement of loans
                    
                    $
                    7,034,351
                    
                    
                    $
                    13,623,602Dividends
      declared, not paid
                    
                    $
                    876,957
                    
                    
                    $
                    1,948,119Exchange
      of loans for mortgage-backed securities
                    
                    $
                    26,242,332
                    
                    
                    $
                    61,965,861
 
 See
Notes to Consolidated Financial Statements.
  4




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)





Note 1.  Basis of
Presentation.The accompanying unaudited consolidated
financial statements are prepared in accordance with accounting principles
generally accepted in the United States of America and with the instructions to
Form 10-Q of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements.  In
the opinion of management, all adjustments necessary for fair presentation of
the financial position and results of operations for the periods presented are
included, none of which are other than normal recurring accruals.  The
financial statements of First South Bancorp, Inc. (the “Company”) and First
South Bank (the “Bank”) are presented on a consolidated basis.  The
results of operations for the three and nine month periods ended September 30,
2010 are not necessarily indicative of the results of operations that may be
expected for the year ended December 31, 2010.





Note 2.  Earnings Per
Share.Basic and diluted earnings per share for the three and
nine month periods ended September 30, 2010 are based on weighted average shares
of common stock outstanding, excluding treasury shares.   Diluted
earnings per share include the potentially dilutive effects of the Company’s
stock option plan.  For the three and nine month periods ended
September 30, 2010, there were none and 234 stock options, respectively, that
were dilutive because their exercise prices exceeded the average market price of
the Company’s common stock, compared to 75 and 25 stock options, respectively,
that were dilutive for the three and nine months ended September 30,
2009.





Note 3. Allowance for Credit
Losses.Activity in the allowance for credit losses, including
the allowances for loan and lease losses and unfunded loan commitments, is
summarized as follows:





Allowance for
                  Loan and
                  Lease Losses
                
                
                Allowance for
                  Unfunded
                  Commitments
                
                
                Allowance For
                  Credit LossesBalance
      at December 31, 2009
                
                $
                13,503,940
                
                
                $
                240,282
                
                
                $
                13,744,222Provision
      for credit losses
                
                
                2,420,000
                
                
                
                -
                
                
                
                2,420,000Reclassification
                
                
                62,313
                
                
                
                (62,313
                )
                
                
                -Loans
      and leases charged-off
                
                
                (2,841,550
                )
                
                
                -
                
                
                
                (2,841,550
                )Loans
      and leases recovered
                
                
                76,409
                
                
                
                -
                
                
                
                76,409Net
      (charge-offs)/recoveries
                
                
                (2,765,141
                )
                
                
                -
                
                
                
                (2,765,141
                )Balance
      at March 31, 2010
                
                
                13,221,112
                
                
                
                177,969
                
                
                
                13,399,081Provision
      for credit losses
                
                
                2,070,000
                
                
                
                -
                
                
                
                2,070,000Reclassification
                
                
                6,733
                
                
                
                (6,733
                )
                
                
                -Loans
      and leases charged-off
                
                
                (7,532,178
                )
                
                
                -
                
                
                
                (7,532,178
                )Loans
      and leases recovered
                
                
                185,626
                
                
                
                -
                
                
                
                185,626Net
      (charge-offs)/recoveries
                
                
                (7,346,552
                )
                
                
                -
                
                
                
                (7,346,552
                )Balance
      at June 30, 2010
                
                
                7,951,293
                
                
                
                171,236
                
                
                
                8,122,529Provision
      for credit losses
                
                
                3,961,787
                
                
                
                -
                
                
                
                3,961,787Reclassification
                
                
                8,269
                
                
                
                (8,269
                )
                
                
                -Loans
      and leases charged-off
                
                
                (3,866,607
                )
                
                
                -
                
                
                
                (3,866,607
                )Loans
      and leases recovered
                
                
                556,635
                
                
                
                -
                
                
                
                556,635Net
      (charge-offs)/recoveries
                
                
                (3,309,972
                )
                
                
                -
                
                
                
                (3,309,972
                )Balance
      at September 30, 2010
                
                $
                8,611,377
                
                
                $
                162,967
                
                
                $
                8,774,344


5





Allowance for Credit Losses Ratios
                
                September 30,
                  2010
                
                
                December 31,
                  2009Allowances
      for loan and lease losses/total loans and leases
                
                
                1.32
                %
                
                
                2.00
                %Allowance
      for unfunded loan commitments/unfunded commitments
                
                
                0.20
                %
                
                
                0.27
                %Allowance
      for credit losses/total loans and leases
                
                
                1.35
                %
                
                
                2.04
                %





Note 4. Comprehensive
Income.Comprehensive income includes net income and all other
changes to the Company's equity, with the exception of transactions with
stockholders ("other comprehensive income").  The Company's only
component of other comprehensive income is unrealized gains and losses on
available for sale securities.  Unrealized gains and losses on
available for sale securities is primarily impacted by purchases and sales of
available for sale securities and changes in interest rates between the
respective reporting periods.  Information concerning other
comprehensive income for the three and nine month periods ended September 30,
2010 and 2009 is as follows:





Three Months
                  Ended
                  9/30/10
                
                
                Three Months
                  Ended
                  9/30/09
                
                
                Nine Months
                  Ended
                  9/30/10
                
                
                Nine Months
                  Ended
                  9/30/09Net
      income
                
                $
                1,009,611
                
                
                $
                1,761,669
                
                
                $
                4,117,671
                
                
                $
                5,526,066Reclassification
      of gain on sale of securities
                
                
                696,410
                
                
                
                0
                
                
                
                1,634,297
                
                
                
                917,866Gains
      (losses) unrealized, net of income taxes
                
                
                (677,020
                )
                
                
                815,478
                
                
                
                17,968
                
                
                
                (1,112,362
                )Other
      comprehensive income (loss)
                
                
                19,390
                
                
                
                815,478
                
                
                
                1,652,265
                
                
                
                (194,496
                )Comprehensive
      income
                
                $
                1,029,001
                
                
                $
                2,577,147
                
                
                $
                5,769,936
                
                
                $
                5,331,570





Note 5.  Stock-Based
Compensation.The Company had two stock-based compensation
plans at September 30, 2010.  The shares outstanding are for grants
under the Company’s 1997 Stock Option Plan (the “1997 Plan”) and the 2008 Equity
Incentive Plan (the “2008 Plan”).  The 1997 Plan matured on April 8,
2008 and no additional options may be granted under the 1997 Plan.  At
September 30, 2010, the 1997 Plan had 123,741 granted unexercised shares. At
September 30, 2010, the 2008 Plan includes 73,000 granted unexercised shares and
885,000 shares available to be granted. During the three and nine months ended
September 30, 2010, no restricted shares were granted under the 2008
Plan.





Stock
options expire ten years from the date of grant and vest over service periods
ranging from one year to five years.  Options granted under the 2008
Plan are granted at the closing sales price of the Company’s common stock on the
NASDAQ Stock Market on the date of grant. The Company settles stock option
exercises with treasury shares.





The net
compensation cost charged against income for the Plans was $31,145 and $74,626
for the three and nine months ended September 30, 2010, compared to $74,036 and
$45,879 of compensation benefits credited against expense for the three and nine
months ended September 30, 2009. Total recapture credits against compensation
expense due to forfeited options was $10,952 for both the three and nine months
ended September 30, 2010, compared to $93,061 and $96,272 for the three and nine
months ended September 30, 2009. As of September 30, 2010, total unrecognized
compensation cost on granted unexercised shares was $208,716. That cost is
expected to be recognized during the next 3.25 years.





No income
tax benefits were recognized from the exercise of stock options in either the
three or nine months ended September 30, 2010 or 2009.


6


There
were no options granted during the three months ended September 30,
2010.  The average fair value of options granted during the nine
months ended September 30, 2010 was $4.25, compared to $4.90 and $4.17 during
the three and nine months ended September 30, 2009.  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 in the three and nine months ended September 30, 2010 and
2009:





Three Months
                    Ended
                    9/30/10
                  
                  
                  Three Months
                    Ended
                    9/30/09
                  
                  
                  Nine Months
                    Ended
                    9/30/10
                  
                  
                  Nine Months
                    Ended
                    9/30/09Dividend
      growth rate
                  
                  
                  N/A
                  
                  
                  
                  5.3
                  %
                  
                  
                  5.3
                  %
                  
                  
                  5.3
                  %Expected
      volatility
                  
                  
                  N/A
                  
                  
                  
                  37.1
                  %
                  
                  
                  36.6
                  %
                  
                  
                  36.6
                  %Average
      risk-free interest rate
                  
                  
                  N/A
                  
                  
                  
                  3.1
                  %
                  
                  
                  3.0
                  %
                  
                  
                  2.8
                  %Expected
      lives - years
                  
                  
                  N/A
                  
                  
                  
                  6
                  
                  
                  
                  6
                  
                  
                  
                  6





A summary
of option activity under the Plans as of September 30, 2010 and 2009, and
changes during the three and nine month periods ended September 30, 2010 and
2009, is presented below:





Period Ended September 30, 2010:
                    
                    Options
                      Outstanding
                    
                    
                    Price
                    
                    
                    Aggregate
                      Intrinsic ValueOutstanding
      at December 31, 2009
                    
                    
                    171,770
                    
                    
                    $
                    16.04Granted
                    
                    
                    27,000
                    
                    
                    $
                    11.11Forfeited
                    
                    
                    (3,500
                    )
                    
                    $
                    18.02Exercised
                    
                    
                    (1,675
                    )
                    
                    $
                    5.50Outstanding
      at March 31, 2010
                    
                    
                    193,595
                    
                    
                    $
                    15.41
                    
                    
                    $
                    (562,874
                    )Granted
                    
                    
                    7,000
                    
                    
                    $
                    12.29Forfeited
                    
                    
                    (3,854
                    )
                    
                    $
                    16.03Exercised
                    
                    
                    0
                    
                    
                    $
                    0.00Outstanding
      at June 30, 2010
                    
                    
                    196,741
                    
                    
                    $
                    15.28
                    
                    
                    $
                    (919,650
                    )Granted
                    
                    
                    0
                    
                    
                    $
                    .00Forfeited
                    
                    
                    0
                    
                    
                    $
                    .00Exercised
                    
                    
                    0
                    
                    
                    $
                    .00Outstanding
      at September 30, 2010
                    
                    
                    196,741
                    
                    
                    $
                    15.28
                    
                    
                    $
                    (1,055,401
                    )Vested
      and Exercisable at September 30, 2010
                    
                    
                    124,875
                    
                    
                    $
                    16.29
                    
                    
                    $
                    (795,171
                    )Period Ended September 30,
      2009:Outstanding
      at December 31, 2008
                    
                    
                    172,295
                    
                    
                    $
                    17.52Granted
                    
                    
                    15,000
                    
                    
                    $
                    9.73Forfeited
                    
                    
                    (1,375
                    )
                    
                    $
                    28.79Exercised
                    
                    
                    0
                    
                    
                    $
                    0.00Outstanding
      at March 31, 2009
                    
                    
                    185,920
                    
                    
                    $
                    16.81
                    
                    
                    $
                    (1,150,476
                    )Granted
                    
                    
                    3,000
                    
                    
                    $
                    10.71Forfeited
                    
                    
                    0
                    
                    
                    $
                    0.00Exercised
                    
                    
                    0
                    
                    
                    $
                    0.00Outstanding
      at June 30, 2009
                    
                    
                    188,920
                    
                    
                    $
                    16.71
                    
                    
                    $
                    (965,604
                    )Granted
                    
                    
                    15,500
                    
                    
                    $
                    12.80Forfeited
                    
                    
                    (27,200
                    )
                    
                    $
                    20.55Exercised
                    
                    
                    (2,500
                    )
                    
                    $
                    6.87Outstanding
      at September 30, 2009
                    
                    
                    174,720
                    
                    
                    $
                    15.91
                    
                    
                    $
                    (770,109
                    )Vested
      and Exercisable at September 30, 2009
                    
                    
                    109,062
                    
                    
                    $
                    15.41
                    
                    
                    $
                    (426,955
                    )


7


The
intrinsic value of options exercised during the nine months ended September 30,
2010 was $11,357, compared to $12,823 of intrinsic value of options exercised
during both the three and nine months ended September 30, 2009.





The
following table summarizes additional information about the Company’s
outstanding options and exercisable options as of September 30, 2010, 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$6.17
      – 13.82
                
                
                96,408
                
                
                
                6.13
                
                
                $
                10.27
                
                
                
                39,408
                
                
                $
                8.65$14.97
      – 16.49
                
                
                36,208
                
                
                
                2.32
                
                
                $
                16.09
                
                
                
                36,208
                
                
                $
                16.09$16.77
      – 25.22
                
                
                50,875
                
                
                
                6.38
                
                
                $
                20.68
                
                
                
                37,459
                
                
                $
                20.56$26.17
      – 33.27
                
                
                13,250
                
                
                
                5.34
                
                
                $
                28.82
                
                
                
                11,800
                
                
                $
                28.83196,741
                
                
                
                5.44
                
                
                $
                15.28
                
                
                
                124,875
                
                
                $
                16.29





A summary
of nonvested option shares as of September 30, 2010 and 2009, and changes during
the three and nine month periods ended September 30, 2010 and 2009, is presented
below:





Period Ended September 30,
      2010:
                      
                      Shares
                      
                      
                      PriceNonvested
      at December 31, 2009
                      
                      
                      58,158
                      
                      
                      $
                      16.16Granted
                      
                      
                      27,000
                      
                      
                      $
                      11.11Forfeited
                      
                      
                      (3,500
                      )
                      
                      $
                      18.02Vested
                      
                      
                      (8,950
                      )
                      
                      $
                      16.05Nonvested
      at March 31, 2010
                      
                      
                      72,708
                      
                      
                      $
                      14.21Granted
                      
                      
                      7,000
                      
                      
                      $
                      12.29Forfeited
                      
                      
                      (2,500
                      )
                      
                      $
                      12.95Vested
                      
                      
                      (3,425
                      )
                      
                      $
                      22.31Nonvested
      at June 30, 2010
                      
                      
                      73,783
                      
                      
                      $
                      13.69Granted
                      
                      
                      0
                      
                      
                      $
                      .00Forfeited
                      
                      
                      0
                      
                      
                      $
                      .00Vested
                      
                      
                      (1,917
                      )
                      
                      $
                      19.36Nonvested
      at September 30, 2010
                      
                      
                      71,866
                      
                      
                      $
                      13.54Period Ended September 30,
      2009:Nonvested
      at December 31, 2008
                      
                      
                      43,275
                      
                      
                      $
                      22.68Granted
                      
                      
                      15,000
                      
                      
                      $
                      9.73Forfeited
                      
                      
                      0
                      
                      
                      $
                      0.00Vested
                      
                      
                      (4,150
                      )
                      
                      $
                      24.22Nonvested
      at March 31, 2009
                      
                      
                      54,125
                      
                      
                      $
                      18.97Granted
                      
                      
                      3,000
                      
                      
                      $
                      10.71Forfeited
                      
                      
                      0
                      
                      
                      $
                      0.00Vested
                      
                      
                      (4,050
                      )
                      
                      $
                      23.34Nonvested
      at June 30, 2009
                      
                      
                      53,075
                      
                      
                      $
                      18.17Granted
                      
                      
                      15,500
                      
                      
                      $
                      12.80Forfeited
                      
                      
                      (1,000
                      )
                      
                      $
                      27.57Vested
                      
                      
                      (1,917
                      )
                      
                      $
                      19.36Nonvested
      at September 30, 2009
                      
                      
                      65,658
                      
                      
                      $
                      16.72


8





The fair
value compensation cost recognition provisions for share based payments are
different from the recognition provisions of the intrinsic value method for
recording compensation cost. The following table reflects the net impact of fair
value compensation cost recognition on income before income taxes, net income,
basic earnings per share and diluted earnings per share for the three and nine
months ended September 30, 2010 and 2009:


Three
                    Months
                    Ended
                    09/30/10
                  
                  
                  Three
                    Months
                    Ended
                    09/30/09
                  
                  
                  Nine
                    Months
                    Ended
                    09/30/10
                  
                  
                  Nine
                    Months
                    Ended
                    09/30/09Increase
      (decrease) net income before income taxes
                  
                  $
                  (31,145
                  )
                  
                  $
                  74,036
                  
                  
                  $
                  (74,626
                  )
                  
                  $
                  45,879Increase
      (decrease) net income
                  
                  $
                  (30,402
                  )
                  
                  $
                  74,036
                  
                  
                  $
                  (72,839
                  )
                  
                  $
                  45,879Increase
      (decrease) basic earnings per share
                  
                  $
                  (0.01
                  )
                  
                  $
                  0.01
                  
                  
                  $
                  (0.01
                  )
                  
                  $
                  0.01Increase
      (decrease) diluted earnings per share
                  
                  $
                  (0.01
                  )
                  
                  $
                  0.01
                  
                  
                  $
                  (0.01
                  )
                  
                  $
                  0.01





Note 6.  Fair Value
Hierarchy.  A fair value hierarchy prioritizes the inputs of
valuation techniques used to measure fair value of nonfinancial assets and
liabilities. The inputs are evaluated and an overall level for the fair value
measurement is determined. This overall level is an indication of the market
observability of the fair value measurement. Financial accounting standards
clarify fair value in terms of the price in an orderly transaction between
market participants to sell an asset or transfer a liability in the principal
(or most advantageous) market for the asset or liability at the measurement date
(an exit price). In order to determine the fair value or the exit price, the
Bank must determine the unit of account, highest and best use, principal market,
and market participants.  These determinations allow the Bank to
define the inputs for fair value and level of hierarchy.  Outlined
below is the application of the fair value hierarchy to the Bank’s financial
assets that are carried at fair value.





Level
1-inputs to the valuation methodology are quoted prices (unadjusted) in active
markets for identical assets or liabilities that the reporting entity has the
ability to access at the measurement date. A quoted price in an active market
provides the most reliable evidence of fair value and shall be used to measure
fair value whenever available. The type of assets carried at Level 1 fair value
generally includes investments such as U. S. Treasury and U. S. government
agency securities.





Level
2-inputs to the valuation methodology include quoted prices for similar assets
or liabilities in active markets and price quotations can vary substantially
either over time or among market makers. The type of assets carried at Level 2
fair value generally includes investment securities such as Government Sponsored
Enterprises (“GSEs”) and the Bank’s investment in other real estate
owned.





Level
3-inputs to the valuation methodology are unobservable to the extent that
observable inputs are not available.  Unobservable inputs are
developed based on the best information available in the circumstances and might
include the Bank’s own assumptions.  The Bank shall not ignore
information about market participant assumptions that is reasonably available
without undue cost and effort. The type of assets carried at Level 3 fair value
generally include investments backed by non-traditional mortgage loans or
certain state or local housing agency obligations,  of which the Bank
has no such assets or liabilities.


9





Assets
measured at fair value on a recurring basis as of September 30, 2010 and
2009:





Quoted Prices
                    In Active
                    Markets for
                    Identical Assets
                  
                  
                  Significant
                    Other
                    Observable
                    Inputs
                  
                  
                  Significant
                    Unobservable
                    InputsDescription
                  
                  9/30/10
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Available
      for sale securities:Mortgage-backed
                  
                  $
                  86,921,971
                  
                  
                  $
                  -
                  
                  
                  $
                  86,921,971
                  
                  
                  $
                  -Total
      September 30, 2010
                  
                  $
                  86,921,971
                  
                  
                  $
                  -
                  
                  
                  $
                  86,921,971
                  
                  
                  $
                  -





Quoted Prices
                    In Active
                    Markets for
                    Identical Assets
                  
                  
                  Significant
                    Other
                    Observable
                    Inputs
                  
                  
                  Significant
                    Unobservable
                    InputsDescription
                  
                  9/30/09
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Available
      for sale securities:Investment
                  
                  $
                  5,431,669
                  
                  
                  $
                  -
                  
                  
                  $
                  5,431,669
                  
                  
                  $
                  -Mortgage-backed
                  
                  
                  85,677,465
                  
                  
                  
                  -
                  
                  
                  
                  85,677,465
                  
                  
                  
                  -Total
      September 30, 2009
                  
                  $
                  91,109,134
                  
                  
                  $
                  -
                  
                  
                  $
                  91,109,134
                  
                  
                  $
                  -





Assets
measured at fair value on a non-recurring basis as of September 30, 2010 and
2009:





Quoted Prices
                    In Active
                    Markets for
                    Identical Assets
                  
                  
                  Significant
                    Other
                    Observable
                    Inputs
                  
                  
                  Significant
                    Unobservable
                    InputsDescription
                  
                  9/30/10
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Impaired
      loans, net
                  
                  $
                  17,335,280
                  
                  
                  $
                  -
                  
                  
                  $
                  17,335,280
                  
                  
                  $
                  -Other
      real estate owned
                  
                  
                  8,598,517
                  
                  
                  
                  -
                  
                  
                  
                  8,598,517
                  
                  
                  
                  -Total
      September 30, 2010
                  
                  $
                  25,933,797
                  
                  
                  $
                  -
                  
                  
                  $
                  25,933,797
                  
                  
                  $
                  -





Quoted Prices
                    In Active
                    Markets for
                    Identical Assets
                  
                  
                  Significant
                    Other
                    Observable
                    Inputs
                  
                  
                  Significant
                    Unobservable
                    InputsDescription
                  
                  9/30/09
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Impaired
      loans, net
                  
                  $
                  15,336,702
                  
                  
                  $
                  -
                  
                  
                  $
                  15,336,702
                  
                  
                  $
                  -Other
      real estate owned
                  
                  
                  12,474,026
                  
                  
                  
                  -
                  
                  
                  
                  12,474,026
                  
                  
                  
                  -Total
      September 30, 2009
                  
                  $
                  27,810,728
                  
                  
                  $
                  -
                  
                  
                  $
                  27,810,728
                  
                  
                  $
                  -





Quoted
market price for similar assets in active markets is the valuation technique for
determining fair value of available for sale securities. Unrealized gains on
available for sale securities are included in the “accumulated other
comprehensive income” component of the Stockholders’ Equity section of the
Consolidated Statements of Financial Condition.


10





The
Company does not record loans at fair value on a recurring basis. However, when
a loan is considered impaired, an impairment write down is taken, based on the
estimated fair value of the loan. The fair value of impaired loans is estimated
using one of several methods, including collateral value, market value of
similar debt, enterprise value, liquidation value and discounted cash flows.
Those impaired loans not requiring a write down represent loans for which the
fair value of the expected repayments or collateral exceed the recorded
investments in such loans. Impaired loans where a write down is taken based on
fair value of collateral require classification in the fair value hierarchy.
When the fair value of the collateral is based on an observable market price or
a current appraised value, the Company records the impaired loan as
non-recurring Level 2. When an appraised value is not available or management
determines the fair value of the collateral is further impaired below the
appraised value and there is no observable market price, the Company classifies
the impaired loan as non-recurring Level 3.





Other
real estate owned (“OREO”) acquired through loan foreclosure is recorded at fair
value upon transfer of the loans to foreclosed assets, based on the appraised
market value of the property. Subsequently, foreclosed assets are carried at the
lower of carrying value or fair value. Fair value is based upon independent
market prices, appraised values of the collateral or management’s estimation of
the value of the collateral. When fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
foreclosed asset as non-recurring Level 2. When an appraised value is not
available or management determines the fair value of the collateral is impaired
below the appraised value and there is no observable market price, the Company
classifies the foreclosed asset as non-recurring Level 3.  Fair value
adjustments of $672,571 and $2,376,771 were made to OREO during the three and
nine months ended September 30, 2010, compared to $449,185 and $1,815,185 during
the three and nine months ended September 30, 2009.





Net gains
(losses) realized and included in earnings for the three and nine months ended
September 30, 2010 and 2009 are reported in other revenues as
follows:





Three
                    Months
                    Ended
                    9/30/10
                  
                  
                  Three
                    Months
                    Ended
                    9/30/09
                  
                  
                  Nine
                    Months
                    Ended
                    9/30/10
                  
                  
                  Nine
                    Months
                    Ended
                    9/30/09Gain
      (loss) on sale of real estate, net
                  
                  $
                  39,858
                  
                  
                  $
                  (86,875
                  )
                  
                  $
                  73,578
                  
                  
                  $
                  (161,323
                  )





No
liabilities were measured at fair value on a recurring or non-recurring basis
during the three and nine months periods ended September 30, 2010 or
2009.





Item
2.  Management's Discussion and Analysis of Financial Condition and
Results of Operation.


First
South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common
stock and owning 100% of the stock of First South Bank (the "Bank") and
operating through the Bank a commercial banking business.  Therefore,
the discussion below focuses primarily on the Bank's results of
operations.  The Bank has one significant operating segment, the
providing of general commercial banking services to its markets located in the
state of North Carolina.  The Company’s common stock is traded on the
NASDAQ Global Select Market under the symbol "FSBK".





Comparison of Financial Condition at
September 30, 2010 and December 31, 2009.Total assets were
$811.9 million at September 30, 2010 compared to $829.9 million at December 31,
2009. Earning assets were $738.5 million at September 30, 2010 compared to
$761.9 million at December 31, 2009, reflecting the net change in the
composition of earning assets, as further discussed below. Earning assets were
91.0% of total assets at September 30, 2010 compared to 91.8% at December 31,
2009.





Interest-bearing
overnight deposits in financial institutions increased to $24.5 million at
September 30, 2010, from $11.9 million at December 31, 2009. Overnight funds are
available to fund loan originations, liquidity management activities and daily
operations of the Bank.


11





No
investment securities were held as available for sale at September 30, 2010,
compared to $407,000 at December 31, 2009. There were no maturities of
investment securities available for sale during the quarters ended September 30,
2010, compared to $5.0 million for the three months ending September 30, 2009
and $15.0 million during the nine months ended September 30,
2009.  The Bank sold $507,000 of investment securities available for
sale during the three and nine months ended September 30, 2010, compared to none
sold during the three months ending September 30, 2009, and $20.9 million sold
during the nine months ending September 30, 2009.





Mortgage-backed
securities available for sale were $86.9 million at September 30, 2010 compared
to $96.7 million at December 31, 2009. The Bank may sell mortgage-backed
securities to support a more balanced sensitivity to future interest rate
changes and may securitize mortgage loans held for sale into mortgage-backed
securities to support adequate liquidity levels.  During the three and
nine months ended September  30, 2010, the Bank sold $15.6 million and
$33.0 million of mortgage-backed securities available for sale, compared to none
for the three and nine months ended September 30, 2009. During the three and
nine months ended September 30, 2010, $11.4 million and $26.2  million
of mortgage loans held for sale were securitized into mortgage-backed securities
available for sale, compared to $5.7 million for the three months and $62.0
million for the nine months ended September 30, 2009.





Mortgage-backed
securities held for investment were $323,000 at September 30, 2010, compared to
$514,000 at December 31, 2009, reflecting scheduled principal
payments.





Based on
current market prices, investment and mortgage-backed securities available for
sale increased in market value by a net of $1.7 million at September 30, 2010
from December 31, 2009. See “Note 4. Comprehensive Income” of “Notes to
Consolidated Financial Statements (Unaudited)” for additional
information.





Loans
held for sale were $5.2 million at September 30, 2010 compared to $6.5 million
at December 31, 2009.  Proceeds from loan sales were $13.0 million and
$30.1 million for the three and nine months ended September 30, 2010, compared
to $15.6 million and $25.4 million sold during the three and nine months ended
September 30, 2009. The proceeds from loans sold during the three and nine
months ended September 30, 2010 were used to fund liquidity needs of the Bank,
including new loan originations, repayment of borrowings, deposit outflows and
general banking operations.  Loans serviced for others were $307.4
million at September 30, 2010, compared to $289.3 million at December 31,
2009.





Net loans
and leases receivable held for investment declined to $637.2 million at
September 30, 2010 from $652.1 million at December 31, 2009. During the three
and nine months ended September 30, 2010, certain loans held for investment were
subjects of foreclosure and transferred to other real estate owned, as discussed
below. In addition, a portion of the proceeds from principal repayments on loans
held for investment was used to fund the liquidity needs of the
Bank.





Non-performing
loans increased to $19.2 million at September 30, 2010, from $10.2 million at
December 31, 2009, as the current economy continues to present a challenging
credit environment for the Bank and its customers. Included in non-performing
loans are restructured loans of $5.2 million at September 30, 2010 and $4.3
million at December 31, 2009.  The level of non-performing loans is
primarily attributable to the current economic environment.  Downward
pressure has impacted the market values of housing and other real estate,
significantly impacting property values in the Bank’s market area and credit
quality of certain borrowers. Management believes it has thoroughly evaluated
its non-performing loans and they are either well collateralized or adequately
reserved. However, there can be no assurance in the future that regulators,
increased risks in the loan portfolio, adverse changes in economic conditions or
other factors will not require further adjustments to the allowance for credit
losses.


12





Other
real estate owned declined to $8.6 million at September 30, 2010 from $10.6
million at December 31, 2009, reflecting the net of sales, new foreclosures of
certain non-performing loans and fair value adjustments. During the nine month
period ended September 30, 2010 there were $7.0 million of new foreclosures,
$6.5 million of sales and $2.5 million of fair value adjustments. Other real
estate owned consists of residential and commercial properties, developed
building lots and a partially developed residential subdivision. The Bank
believes the adjusted carrying values of these properties are representative of
their fair market values, although there can be no assurances that the ultimate
sales will be equal to or greater than the carrying values.  See “Note
6.  Fair Value Hierarchy” of “Notes to Consolidated Financial
Statements (Unaudited)” for additional information.





Total
deposits increased to $696.1 million at September 30, 2010 from $688.5 million
at December 31, 2009.  Demand accounts (personal and business checking
accounts and money market accounts) increased to $237.7 million at September 30,
2010 from $224.5 million at December 31, 2009.





Time
deposits increased to $433.4 million at September 30, 2010, from $440.9 million
at December 31, 2009.  During this period, the Bank chose to not match
higher time deposit rates being offered by certain competitor financial
institutions in its market area, in order to control its time deposit
cost.  The Bank has been pricing new and maturing time deposits within
the current lower rate environment, and combined with the growth of lower cost
checking accounts, is effectively managing its deposit cost.  See
“Interest Expense” below for additional information regarding the Bank’s cost of
funds.





Borrowed
money consisting of Federal Home Loan Bank (“FHLB”) advances and repurchase
agreements declined to $12.2 million at September 30, 2010 from $37.4 million at
December 31, 2009.  FHLB advances declined to $10.0 million at
September 30, 2010, from $35.0 million at December 31, 2009 as the Bank
repaid a $25.0 million, 3.0% fixed-rate advance.  Repurchase
agreements (representing cash management accounts for commercial banking
customers) were $2.2 million at September 30, 2010, compared to $2.4 million at
December 31, 2009.





Stockholders'
equity was $87.3 million at September 30, 2010 and $86.2 million at December 31,
2009, reflecting the net effect of earnings, dividend payments and changes in
accumulated other comprehensive income.  The equity to assets ratio
increased to 10.8% at September 30, 2010, from 10.4% at December 31, 2009. See
"Consolidated Statements of Stockholders' Equity" for additional
information.





Accumulated
other comprehensive income was $2.0 million at September 30, 2010 compared to
$322,000 at December 31, 2009, reflecting the net increase in unrealized gains
on available for sale securities portfolio based on current market
prices.  See “Note 4. Comprehensive Income” of “Notes to Consolidated
Financial Statements (Unaudited)” for additional information.





The Bank
is subject to various capital requirements administered by federal and state
banking agencies. As of September 30, 2010, the Bank's regulatory capital ratios
were in excess of all regulatory requirements and are as follows: Total
Risk-Based Capital – 13.8%; Tier 1 Risk-Based Capital – 12.6 %; and Tier 1
Leverage Capital – 9.9%.  See "Liquidity and Capital Resources" below
for additional information.





On
September 23, 2010, the Company declared a cash dividend of $0.09 per share,
payable October 28, 2010 to stockholders of record as of October 4,
2010.  This dividend payment represents a 90.0% payout ratio of the
basic earnings per share for the quarter ended September 30, 2010, and is the
Company's 54th consecutive quarterly cash dividend.  The Board of
Directors (the “Board”) adjusted the quarterly cash dividend payment rate from
$0.20 per share for the preceding quarter end  based on guidance
provided by the Federal Reserve Bank of Richmond (the “Fed”), the Company’s
primary federal regulatory agency.  The Fed guidance stated that the
Company is expected to act as a source of strength to the Bank and the payment
of dividends exceeding net income is questionable in these uncertain times, as
continued high levels of loan losses and problem loans can require significant
capital.  The Fed considers it more prudent to reduce stockholder
dividends at this point and maintain capital in the Bank.


13





While the
Company has continued with positive earnings and capital levels significantly in
excess of the requirements to be well capitalized, the Board concurred with the
Fed’s guidance and felt it was appropriate in consideration of their guidance to
adjust the quarterly cash dividend payment rate accordingly.  In
addition, future dividends will depend upon the Company’s financial condition,
earnings, equity structure, capital needs, economic conditions and regulatory
requirements and recommendations.





The
Company purchased none of its common stock during the three and nine months
ended September 30, 2010.  Common stock may be purchased through
private or open market transactions pursuant to a stock repurchase program
adopted by the Board. Shares acquired through the repurchase plan are held as
treasury stock, at cost. The Company has placed the repurchase program in an
inactive status and no shares have been purchased during the current fiscal
year.  At September 30, 2010, there were 1,510,251 treasury shares
totaling $32.1 million, compared to 1,511,926 shares totaling $32.2 million at
December 31, 2009.  Treasury shares are used for general purposes
including the exercise of stock options and providing shares for potential
future stock splits.





From
December 31, 2009 to September 30, 2010, there were 1,675 shares of the
Company’s common stock issued from the exercise of stock options.





Comparison of Operating Results -
Three and Nine Months Ended September 30, 2010 and 2009.Net
income for the three and nine months ended September 30, 2010 was $1.0 million
and $4.1 million, compared to $1.8 million and $5.5 million for the three and
nine months ended September 30, 2009. Diluted earnings per share were $0.10 and
$0.42 per share for the three and nine months ended September 30, 2010, compared
to $0.18 and $0.57 per share for the three and nine months ended September 30,
2009.




Net
earnings during the three and nine months ended September 30, 2010 were
favorably impacted by an increase in net interest income, while being partially
offset by the volume of provisions for credit losses to replenish net
charge-offs.  The current economy continues to present a challenging
credit environment for the Bank, for its customers and for the banking
industry.  As the Bank addresses and manages through these challenges,
it remains focused on long-term strategies.  These strategies include
remediating problem assets, maintaining adequate levels of capital and
liquidity, improving efficiency in operations, building core customer
relationships and improving franchise value along with stockholder
value.  The Bank remains profitable, continues to maintain a strong
capital position in excess of the well-capitalized regulatory guidelines, and
combined with strengthening of the allowance for credit losses should enhance
future earnings as the current economic conditions substantially
improve.





Key
performance ratios are return on average assets (ROA), return on average equity
(ROE), and efficiency.  ROA was .5% and .7% for the three and nine
months ended September 30, 2010, compared to 0.8% for both the three and nine
months ended September 30, 2009.  ROE was 4.6% and 6.3% for the three
and nine months ended September 30, 2010, compared to 8.1% and 8.4% for the
three and nine months ended September 30, 2009.  The efficiency ratio
was 55.5% and 57.0% for the three and nine months ended September 30, 2010,
compared to 61.1% and 58.5% for the three and nine months ended September 30,
2009.


14





Interest
Income.Interest income declined to $11.0 million and $32.9
million for the three and nine months ended September 30, 2010, from $12.2
million and $37.2 million for the three and nine months ended September 30,
2009. The reduction in interest income volume is due primarily to the decline in
interest rates during the comparative reporting periods and a decline in the
volume of average interest-earning assets. Average interest-earning assets
declined to $741.2 million and $742.3 million for the three and nine months
ended September 30, 2010, from $801.6 million and $809.1 million for the three
and nine months ended September 30, 2009.  The reduction in average
interest-earning assets reflects the net impact of the decrease in loans held
for investment, sales and maturities of investment securities and mortgage
backed securities, and the volume of other real estate owned and non-performing
loans discussed above.  The yield on average interest-earning assets
declined to 5.9% for both the three and nine months ended September 30, 2010,
from 6.1% for both the three and nine months ended September 30,
2009.  The yield on average interest-earning assets has been impacted
by the decline in interest rates and average interest-earning assets during the
comparative reporting periods as discussed above.





Interest
Expense.Interest expense declined to $2.2 million and $6.9
million for the three and nine months ended September 30, 2010, from $3.9
million and $13.1 million for the three and nine months ended September 30,
2009, reflecting a decline in interest rates between the comparative reporting
periods and a decline in the volume of average interest-bearing
liabilities.  The effective cost of funds improved to 1.2% and 1.3%
for the three and nine months ended September 30, 2010, from 2.0% and 2.2% for
the three and nine months ended September 30, 2009.  The Company was
able to improve its cost of funds by the combination of deposit repricing, the
rollover of maturing time deposits and the repositioning of borrowings within
the current lower interest rate environment.  Average deposits and
borrowings declined to $718.7 million and $717.9 million for the three and nine
months ended September 30, 2010, from $771.9 million and $778.1 million for the
three and nine months ended September 30, 2009.





Net Interest Income.Net interest income
increased to $8.7 million and $26.1 million for the three and nine months ended
September 30, 2010, from $8.3 million and $24.1 million for the three and nine
months ended September 30, 2009.  The interest rate spread (the
difference between the effective yield on average earning assets and the
effective cost of average deposits and borrowings) improved to 4.7% and 4.6% for
the three and nine months ended September 30, 2010, from 4.1% and 3.9% for the
three and nine months ended September 30, 2009. The net interest margin on
interest-earning assets (net interest income divided by average interest-earning
assets) improved to 4.7% for both the three and nine months ended September 30,
2010, compared to 4.1% and 4.0% for the three and nine months ended September
30, 2009.The increase
in interest rate spread and net yield on interest-earning assets is a result of
effectively managing the rates earned and paid and the volume of
interest-earning assets and interest-bearing liabilities.





Provision for Credit
Losses.  The Bank's methodology for determining its provision
for credit losses includes amounts specifically allocated to credits that are
individually determined to be impaired, as well as general provisions allocated
to groups of loans that have not been individually assessed for
impairment.  The Bank recorded $4.0 million and $8.5 million of
provisions for credit losses in the three and nine months ended September 30,
2010, compared to $1.3 million and $4.5 million in the three and nine months
ended September 30, 2009, reflecting the current volume of non-performing loans
as previously discussed. The provision for credit losses was necessary to
replenish net charge offs of $3.3 million and $13.4 million recorded in the
three and nine months ended September 30, 2010 compared to $668,000 and $3.9
million in the three and nine months ended September 30, 2009, and to strengthen
the Bank’s ability to better manage the volume of non-performing loans, as
discussed above. See “Allowance for Credit Losses” below for additional
information.


15





Allowance for Credit
Losses.The Bank maintains allowances for loan and lease
losses and for unfunded loan commitments (collectively the “allowance for credit
losses”) at levels the Bank believes are adequate to absorb probable losses
inherent in the loan and lease portfolio and in unfunded loan
commitments.  The Bank has developed policies and procedures for
assessing the adequacy of the allowance for credit losses that reflect the
assessment of credit risk and impairment analysis.  This assessment
includes an analysis of qualitative and quantitative trends in the levels of
classified loans.  In developing this analysis, the Bank relies on
historical loss experience, estimates and exercises judgment in assessing credit
risk. Future assessments of credit risk may yield different results, depending
on changes in the qualitative and quantitative trends, which may require
increases or decreases in the allowance for credit losses.





The Bank
uses a variety of modeling, calculation methods and estimation tools for
measuring credit risk and performing impairment analysis, which is the basis
used in developing the allowance for credit losses.  The factors
supporting the allowance do not diminish the fact that the entire allowance for
credit losses is available to absorb probable losses in both the loan and leases
portfolio and in unfunded loan commitments.  The Bank’s principal
focus is on the adequacy of the total allowance for credit losses.





During
the nine months ended September 30, 2010, the Bank refined its allowance for
credit losses methodology taking into account current generally accepted
accounting principles and regulatory guidance. The refined methodology is
focused on current borrower analysis and loss factors that are more indicative
of actual historical loss experience in recent years.  Previously, the
Bank established specific reserves for certain impaired loans.  The
Bank has elected to write down substantially all previously calculated specific
reserves.  Going forward, when impairment can be reasonably
calculated, the Bank will write down the affected loan by the level of that
impairment.  As a result of these changes, this leaves the allowance
for credit losses with a distinctly different balance than in previous reporting
periods, which contained a mixed balance between both general and specific
reserves.  Now essentially the Bank’s entire calculated allowance for
credit losses general reserves.





Based on
the overall credit quality of the loan and lease receivable portfolio,
management believes the Bank has established the allowance for credit losses
pursuant to generally accepted accounting principles, and has taken into account
the views of its regulators and the current economic
environment.  Management reassesses the information upon which it
bases the allowance for credit losses not greater than quarterly and believes
their accounting decisions remain accurate. However, there can be no assurance
in the future that regulators, increased risks in the loan and lease portfolio,
changes in economic conditions and other factors will not require additional
adjustments to the allowance for credit losses.





The
allowance for credit losses was $8.8 million at September 30, 2010, compared to
$13.7 million December 31, 2009. The ratio of the allowance for credit losses to
loans and leases was 1.4% at September 30, 2010, compared to 2.0% at December
31, 2009.  See “Note 3. Allowance for Credit Losses” and “Note
6.  Fair Value Hierarchy” of “Notes to Consolidated Financial
Statements (Unaudited)” and “Critical Accounting Policies - Loan Impairment and
Allowance for Credit Losses” for additional information.





Noninterest
Income.Noninterest income increased to $3.4 million and $8.9
million for the three and nine months ended September 30, 2010, compared to $2.4
million and $8.4 million for the three and nine months ended September 30,
2009.  Noninterest income consists of fees, service charges and
servicing fees earned on loans, service charges and insufficient funds fees
collected on deposit accounts, gains from loan and securities sales and other
miscellaneous income.





The Bank
strives to maintain a consistent level of noninterest income across both loan
and deposit service offerings. Fees, service charges and loan servicing fees
collected were $2.0 million and $5.8 million for the three and nine months ended
September 30, 2010, compared to $2.0 million and $6.0 million for the three and
nine months ended September 30, 2009. Fees, service charges and loan servicing
fees earned during each period are attributable to the volume of the various
types of loan and deposit account transactions processed, the volume of loans
serviced for others and the collection of related fees and service
charges.


16





The Bank
recorded net gains from loan sales of $479,000 and $845,000 during the three and
nine months ended September 30, 2010, compared to $247,000 and $935,000 during
the three and nine months ended September 30, 2009. Fixed-rate residential
mortgage loans are sold to reduce exposure to interest rate and credit risk, and
to provide a more balanced sensitivity to future interest rate
changes.





The Bank
recorded net gains from investment and mortgage-backed securities sales of
$696,000 and $1.6 million during the three and nine months ended September 30,
2010, compared to none during the three months ending September 30, 2009 and
$918,000 during the nine months ended September 30, 2009.  Proceeds
from investment and mortgage-backed securities sales are used for a variety of
purposes, including funding new loan originations, liquidity management and
general banking operations.





Noninterest
Expense.Noninterest expenses were $6.7 million and $20.0
million for the three and nine months ended September 30, 2010, compared to $6.5
million and $19.0 million for the three and nine months ended September 30,
2009.  The largest component, compensation and fringe benefits,
increased to $4.0 million and $11.8 million for the three and nine months ended
September 30, 2010, compared to $3.5 million and $10.5 million for the three and
nine months ended September 30, 2009, reflecting increased staffing levels
necessary to enhance retail banking operations and credit administration, for
providing quality customer service and increased costs of employee health
insurance benefits.





FDIC
insurance premiums were $285,000 and $869,000 for the three and nine months
ended September 30, 2010, compared to $275,000 and $955,000 for the three and
nine months ended September 30, 2009, reflecting the volume of insured deposit
account balances and the impact of the FDIC’s risk-based deposit insurance
assessments.





Expenses
attributable to maintaining the current volume of other real estate owned
declined to $150,000 and $314,000 in the three and nine months ended September
30, 2010, from $394,000 and $737,000 in the three and nine months ended
September 30, 2009.  Other noninterest expenses including premises and
equipment, advertising, data processing, repairs and maintenance, office
supplies, professional fees, taxes and insurance, etc., have remained relatively
consistent during the respective periods.





Income
Taxes.Income tax expense declined to $424,000 and $2.5
million for the three and nine months ended September 30, 2010, from $1.1
million and $3.5 million for the three and nine months ended September 30,
2009.  Changes in amounts of income tax provisions reflect changes in
the volume of pretax income and estimated income tax rates in effect during each
respective period.  The effective income tax rates were 29.6% and
37.4% for the three and nine months ended September 30, 2010, compared to 38.9%
and 38.7% for the three and nine months ended September 30, 2009.  See
“Critical Accounting Policies” for additional information.





Liquidity and Capital
Resources.Liquidity generally refers to the Bank's ability to
generate adequate amounts of funds to meet its cash needs.  Adequate
liquidity guarantees that sufficient funds are available to meet deposit
withdrawals, fund future loan commitments, maintain adequate reserve
requirements, pay operating expenses, provide funds for debt service, pay
dividends to stockholders, and meet other general commitments.  The
Bank must maintain certain regulatory liquidity requirements of liquid assets to
deposits and short-term borrowings.  At September 30, 2010, the Bank
had cash, deposits in banks, investment securities, mortgage-backed securities
and loans held for sale totaling $133.2 million, compared to $133.8 million at
December 31, 2009, representing 18.8% and 18.7% of deposits and short-term
borrowings for the respective periods.


17





The Bank
believes it can meet future liquidity needs with existing funding
sources.  The Bank's primary sources of funds are deposits, payments
on loans and mortgage-backed securities, maturities of investment securities,
earnings and funds provided from operations, the ability to borrow from the FHLB
of Atlanta and the availability of loans held for sale.  While
scheduled repayments of loans and mortgage-backed securities are relatively
predictable sources of funds, deposit flows and general market interest rates,
economic conditions and competition substantially influence loan prepayments. In
addition, the Bank manages its deposit pricing in order to maintain a desired
deposit mix.





The FDIC
requires the Bank to meet a minimum leverage capital requirement of Tier 1
capital (consisting of retained earnings and common stockholders’ equity, less
any intangible assets) to assets ratio of 4%.  The FDIC also requires
the Bank to meet a ratio of total capital to risk-weighted assets of 8%, of
which at least 4% must be in the form of Tier 1 capital.  The North
Carolina Office of the Commissioner of Banks requires the Bank to maintain a
capital surplus of not less than 50% of common capital stock.  The
Bank was in compliance with all regulatory capital requirements at September 30,
2010 and December 31, 2009.





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





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





Loan Impairment and
Allowance for Credit Losses.  A loan or lease is considered
impaired, based on current information and events, if it is probable that the
Bank will be unable to collect the scheduled payments of principal or interest
when due according to the contractual terms of the loan or lease agreement.
Uncollateralized loans are measured for impairment based on the present value of
expected future cash flows discounted at the historical effective interest rate,
while all collateral-dependent loans are measured for impairment based on the
fair value of the collateral.  The Bank uses several factors in
determining if a loan or lease is impaired.  The internal asset
classification procedures include a thorough review of significant loans, leases
and lending relationships and include the accumulation of related
data.  This data includes loan and lease payment status, borrowers'
financial data and borrowers' operating factors such as cash flows, operating
income or loss, etc.





The
allowance for 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 for credit losses is based on past loan and lease
loss experience, known and inherent risks in loans and leases and unfunded loan
commitments, adverse situations that may affect the borrower's ability to repay,
the estimated value of any underlying collateral, and current economic
conditions.  While management believes that it has established the
allowance for credit losses in accordance with accounting principles generally
accepted in the United States of America and has taken into account the views of
its regulators and the current economic environment, there can be no assurance
in the future that regulators or risks in its loans and leases and unfunded loan
commitments will not require additional adjustments to the allowance for credit
losses.





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


18





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





Forward Looking
Statements.The Private Securities Litigation Reform Act of
1995 states that 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 Form 10-Q, including
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 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 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, as actual results may differ
materially from management's expectations.





Accounting Standards
Codification.  In June 2009, the Financial Accounting Standards
Board (the “FASB”) issued Statement of Financial Accounting Standards No. 168
(“SFAS No. 168”), “The FASB Accounting Standards Codification and the
Hierarchy of Generally Accepted Accounting Principles-a replacement of FASB
Statement No. 162.” The FASB Accounting Standards Codification will become the
source of authoritative U.S. GAAP recognized by the FASB to be applied to
nongovernmental entities.





Following
this Statement, the FASB Board will not issue new standards in the form of
Statements, FASB Staff Positions, or Emerging Issues Task Force
Abstracts.  Instead, they will issue Accounting Standards Updates. The
Board will not consider Accounting Standards Updates as authoritative in their
own right.  Accounting Standards Updates will serve only to update the
Codification, provide background information about the guidance and provide the
basis for conclusions on the change(s) in the Codification.





This
statement will replace SFAS No. 162 and modifies the GAAP hierarchy into two
levels: authoritative and non-authoritative. This statement is effective for
financial statements issued for interim and annual periods ending after
September 15, 2009. The Company adopted SFAS No. 168 on September 30, 2009, with
no material impact on its consolidated financial statements.





Going
forward, as the FASB issues Accounting Standards Updates, the Company will
evaluate the impact that such updates may have on its consolidated financial
statements of the Company and will also monitor the effective dates of such
updates.


19





Item 3.  Quantitative and
Qualitative Disclosures about Market Risk.Market risk is the
possible chance of loss from unfavorable changes in market prices and
rates.  These changes may result in a reduction of current and future
period net interest income, which is the favorable spread earned from the excess
of interest income on interest-earning assets over interest expense on
interest-bearing liabilities.





The
Company considers interest rate risk to be its most significant market risk,
which could potentially have the greatest impact on operating
earnings.  The structure of the Company's loan and deposit portfolios
is such that a significant decline in interest rates may have a negative impact
on net market values and net interest income.  The Company monitors
whether material changes in market risk have occurred since December 31,
2009.  The Company believes that no adverse change in market risk
exposure has occurred since December 31, 2009.





The Bank
has experienced intense price competition for both loans and deposits over the
past two years, which presented a net interest margin management
challenge.  Net interest margin management has been significantly
influenced by the Federal Reserve’s 500 basis point rate cuts since September
2007. The Federal Reserve’s aggressive series of rate cuts caused immediate
downward pricing of the Bank’s loan portfolio, while simultaneously outpacing
the ability to reduce its funding cost as rapidly.  With the prime
rate set at 3.25% since December 2008, and the current federal funds rate at 0%
to 0.25%, it is not foreseeable that interest rates can decline
farther.  Over the remainder of 2010, the Bank anticipates little
compression in its net interest margin as maturing time deposits continue to
reprice at lower rates, although there are no guarantees or
assurances.





Item 4.  Controls and
Procedures.As of the end of the
period covered by this report, management of the Company carried out an
evaluation, under the supervision and with the participation of the Company’s
principal executive officer and principal financial officer, of the
effectiveness of the Company’s disclosure controls and procedures. Based on this
evaluation, the Company’s principal executive officer and principal financial
officer concluded that the Company’s disclosure controls and procedures are
effective in ensuring that information required to be disclosed by the Company
in reports that it files or submits under the Securities Exchange Act of 1934,
as amended, is recorded, processed, summarized and reported, within the time
periods specified in the Securities and Exchange Commission’s rules and
forms.  It should be noted that the design of the Company’s disclosure
controls and procedures is based in part upon certain reasonable assumptions
about the likelihood of future events, and there can be no reasonable assurance
that any design of disclosure controls and procedures will succeed in achieving
its stated goals under all potential future conditions, regardless of how
remote, but the Company’s principal executive and financial officers have
concluded that the Company’s disclosure controls and procedures are, in fact,
effective at a reasonable assurance level.





In
addition, there have been no changes in the Company’s internal control over
financial reporting (to the extent that elements of internal control over
financial reporting are subsumed within disclosure controls and procedures)
identified in connection with the evaluation described in the above paragraph
that occurred during the Company’s last fiscal quarter, that has materially
affected, or is reasonably likely to materially affect, the Company’s internal
control over financial reporting.


20





PART
II.  OTHER INFORMATION





Item l.  Legal Proceedings:The Company is currently not engaged in any material legal
proceedings.  From time to time, the Bank is a party to legal
proceedings within the ordinary course of business wherein it enforces its
security interest in loans, and other matters of similar nature.





Item 1A.  Risk Factors:In addition to the risk factors that were disclosed in response to
Item 1A of Part I of Form 10-K for the year ended December 31,
2009, the following risk factor could impact our operations and financial
results:





The
recently enacted Dodd-Frank Act may adversely impact the Company’s results of
operations, financial condition, or liquidity.





On July
21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (the “Dodd-Frank Act”) into law. The Dodd-Frank Act
represents a comprehensive overhaul of the financial services industry in the
United States. The Dodd-Frank Act includes, among other things:





·
            the
      creation of a Financial Stability Oversight Council to identify emerging
      systemic risks posed by financial firms, activities and practices, and to
      improve cooperation between federal
agencies;


·
            the
      creation of a Bureau of Consumer Financial Protection authorized to
      promulgate and enforce consumer protection regulations relating to
      financial products, which would affect both banks and non-bank financial
      companies;


·
            the
      establishment of strengthened capital and prudential standards for banks
      and bank holding companies;


·
            enhanced
      regulation of financial markets, including derivatives and securitization
      markets;


·
            the
      elimination of certain trading activities by
  banks;


·
            a
      permanent increase of the previously implemented temporary increase of
      FDIC deposit insurance to $250,000 per account, an extension of unlimited
      deposit insurance on qualifying noninterest-bearing transaction accounts,
      and an increase in the minimum deposit insurance fund reserve requirement
      from 1.15% to 1.35%, with assessments to be based on assets as opposed to
      deposits;


·
            amendments
      to the Truth in Lending Act aimed at improving consumer protections with
      respect to mortgage originations, including originator compensation,
      minimum repayment standards, and prepayment considerations;
      and


·
            new
      disclosure and other requirements relating to executive compensation and
      corporate governance





Although
the Dodd-Frank Act has been signed into law, a number of provisions remain to be
implemented through the rulemaking process at various regulatory agencies. We
are unable to predict the extent to which the Dodd-Frank Act or the forthcoming
rules and regulations will impact the business of the Company and the Bank.
However, we believe that certain aspects of the new legislation, including,
without limitation, the additional cost of higher deposit insurance coverage and
the costs of compliance with disclosure and reporting requirements and
examinations could have an impact on our business, financial condition, and
results of operations. Additionally, we cannot predict whether there will be
additional proposed laws or reforms that would affect the U.S. financial system
or financial institutions, whether or when such changes may be adopted, how such
changes may be interpreted and enforced, or how such changes may affect
us.


21





Item 2.  Unregistered Sales
of Equity Securities and Use of Proceeds:The following table sets forth
information regarding the Company's repurchases of its Common Stock during the
quarter ended September 30, 2010.


Total Numberof SharesPurchased
                              
                              
                              Maximumas Part of
                              
                              
                              Number of SharesTotal
                              
                              
                              
                              
                              
                              Publicly
                              
                              
                              that May Yet BeNumber of
                              
                              
                              Average
                              
                              
                              Announced
                              
                              
                              Purchased UnderShares
                              
                              
                              Price Paid
                              
                              
                              Plans or
                              
                              
                              the Plans orPeriod
                              
                              Purchased
                              
                              
                              per Share
                              
                              
                              Programs (1)
                              
                              
                              Programs (1)July  2010Beginning
      date: July 1Ending
      date: July 31
                              
                              
                              -0-
                              
                              
                              
                              -0-
                              
                              
                              
                              -0-
                              
                              
                              
                              487,115August
      2010Beginning
      date: August 1Ending
      date: August 31
                              
                              
                              -0-
                              
                              
                              
                              -0-
                              
                              
                              
                              -0-
                              
                              
                              
                              487,115September
      2010Beginning
      date: September 1Ending
      date: September 30
                              
                              
                              -0-
                              
                              
                              
                              -0-
                              
                              
                              
                              -0-
                              
                              
                              
                              487,115





(1)
              487,115
      shares of common stock may be purchased pursuant to a stock repurchase
      program announced on January 19, 2010.  This repurchase program
      will expire on January 18,
2011.




Item 3.  Defaults Upon
Senior Securities:Not applicable





Item
4.  [Reserved]





Item 5.  Other Information:Not applicable





Item 6.  Exhibits:The following exhibits are filed herewith:





Number
                  
                  Title31.1
                  
                  Rule
      13a-14(a) Certification of Chief Executive Officer31.2
                  
                  Rule
      13a-14(a) Certification of Chief Financial Officer32
                  
                  Section
      1350
Certification




22


SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





FIRST
      SOUTH BANCORP, INC.By:
                /s/ William L. Wall
                
                By:
                /s/ Kristie W. HawkinsWilliam
      L. Wall
                
                Kristie
      W. HawkinsExecutive
      Vice President
                
                ControllerChief
      Financial Officer
                
                Treasurer(Principal
      Financial Officer)
                
                (Principal Accounting Officer)Date:
      November 5, 2010
                
                Date:
      November 5, 2010




23