FIRST SOUTH BANCORP INC /VA/ - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

---------------

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the fiscal year ended December 31, 2004

OR

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

For the transition period from _________ to _________

Commission File No. 0-22219

FIRST SOUTH BANCORP, INC.
- --------------------------------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)

Virginia 56-1999749
- ------------------------------- -------------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

1311 Carolina Avenue, Washington, North Carolina 27889-2047
- ------------------------------------------------ ----------
(Address of Principal Executive Offices) (Zip Code)

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

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

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

Common stock, par value $.01 per share
--------------------------------------
(Title of Class)

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

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [_]

At June 30, 2004, the registrant had 6,222,216 shares of its Common Stock, $0.01
par value, outstanding. The aggregate market value of voting stock held by
nonaffiliates of the Corporation at June 30, 2004, was approximately $115.1
million based on the closing sale price of the registrant's Common Stock as
listed on the Nasdaq National Market as of the last business day of the
registrant's most recently completed second fiscal quarter. For purposes of this
calculation, it is assumed that directors, executive officers and beneficial
owners of more than 5% of the registrant's outstanding voting stock are
affiliates.

Number of shares of Common Stock outstanding as of March 1, 2005: 6,313,672.

DOCUMENTS INCORPORATED BY REFERENCE

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

1. Portions of the Annual Report to Stockholders for the fiscal year ended
December 31, 2004. (Parts II and IV)
2. Portions of Proxy Statement for 2005 Annual Meeting of Stockholders.
(Part III)

PART I

Item 1. Business

Forward-Looking Statements

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

General

First South Bancorp, Inc. First South Bancorp, Inc. (the "Company") is a
Virginia corporation that serves as the holding company for First South Bank, a
North Carolina chartered commercial bank (the "Bank"). The Company's principal
business is overseeing the business of the Bank and investing the portion of the
net stock conversion proceeds retained by it.

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

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

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

Market Area

Although the Company makes loans and obtains deposits throughout central,
eastern, northeastern and southeastern North Carolina, where the Bank's offices
are located. As of December 31, 2004, management estimates that more than 95% of
deposits and 90% of loans came from its primary market area.

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

1

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

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

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

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

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

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

2

Lending Activities

General. The Company's gross loan portfolio, including loans in process,
totaled $698.6 million at December 31, 2004, representing 96.9% of total assets
at that date. It is the Company's policy to concentrate its lending within its
market area. The Company originates a significant amount of commercial real
estate loans. At December 31, 2004, commercial real estate loans amounted to
$422.6 million, or 60.5% of the Company's gross loan portfolio. In recent years,
the Company has sought to increase originations of commercial business loans and
consumer loans. At December 31, 2004, commercial business loans totaled $87.1
million, or 12.5% of the Company's gross loan portfolio, and consumer loans
totaled $98.4 million, or 14.1% of the Company's gross loan portfolio. To a
lesser extent, the Company also originates multi-family residential real estate
loans. At December 31, 2004, $53.1 million, or 7.6% of the Company's gross loan
portfolio, consisted of single-family, residential mortgage loans. The Company's
residential mortgage construction loans totaled $22.6 million, or 3.3% of the
Company's gross loan portfolio, at December 31, 2004.

3

Loan Portfolio Composition. The following table sets forth selected data
relating to the composition of the Company's loan portfolio by type of loan at
the dates indicated. At December 31, 2004, the Company had no concentrations of
loans exceeding 10% of gross loans other than as disclosed below.

At December 31 At September 30,
----------------------------------------------------------------- ----------------------------------
2004 2003 2002 2001 2001 2000
-------------- --------------- ----------------- ---------------- ----------------------------------
Amount % Amount % Amount % Amount % Amount % Amount %
-------------- --------------- ----------------- ---------------- ----------------------------------
(Dollars in thousands)

Residential mortgage
loans:
Single-family
residential........... $53,149 7.6% $ 64,549 10.8% $103,852 19.6% $ 110,217 25.7% $ 99,620 25.1% $ 135,572 34.5%
Multi-family
residential........... 2,956 .4 3,650 .6 6,360 1.2 8,399 2.0 9,470 2.4 6,747 1.7
Construction........... 22,687 3.3 9,921 1.7 17,070 3.2 23,305 5.4 23,829 6.0 29,332 7.5
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----
Total residential
mortgage loans..... 78,792 11.3 78,120 13.1 127,282 24.0 141,921 33.1 132,919 33.5 171,651 43.7
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----

Commercial loans and
leases:
Commercial real estate. 422,637 60.5 372,430 62.3 274,564 51.8 172,621 40.3 149,821 37.7 111,062 28.3
Commercial business.... 87,063 12.5 47,646 7.9 39,926 7.5 32,450 7.6 36,019 9.0 34,914 8.9
Lease receivables...... 11,622 1.6 10,422 1.7 6,624 1.3 3,244 .8 88 .1 -- --
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----
Total commercial
loans and leases... 521,322 74.6 430,076 71.9 321,114 60.6 208,315 48.7 185,928 46.8 145,976 37.2
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----

Consumer loans:
Automobile............. 3,890 .5 4,045 .7 4,618 .8 5,674 1.3 6,259 1.6 5,718 1.4
Savings account loans.. 1,394 .2 1,829 .3 2,003 .4 1,438 .3 1,258 .3 997 .3
Home equity loans...... 42,330 6.1 38,533 6.5 35,471 6.7 34,947 8.2 36,826 9.3 35,845 9.1
Other.................. 50,827 7.3 45,072 7.5 39,770 7.5 35,717 8.4 33,842 8.5 32,442 8.3
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----
Total consumer loans. 98,441 14.1 89,479 15.0 81,862 15.4 77,776 18.2 78,185 19.7 75,002 19.1
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----
Total ............. 698,555 100.0% 598,097 100.0% 530,258 100.0% 428,012 100.0% 397,032 100.0% 392,629 100.0%
------- ----- ------- ----- ------- ----- ------- ----- ------- ------ ------- -----

Less:
Loans in process....... 57,194 36,280 31,450 16,220 16,795 20,357
Deferred fees and
discounts............. 1,202 983 935 808 749 903
Allowance for loan
losses................ 8,343 7,634 6,959 5,371 5,401 5,159
-------- -------- -------- -------- -------- --------
Total................ $631,816 $553,200 $490,914 $405,613 $374,087 $366,210
======== ======== ======== ======== ======== ========

4

Loan Maturities. The following table sets forth certain information at
December 31, 2004 regarding the dollar amount of loans maturing in the Company's
portfolio based on their contractual terms to maturity, including scheduled
repayments of principal. Demand loans, loans having no stated schedule of
repayments and no stated maturity, and overdrafts are reported as due in one
year or less. The table does not include any estimate of prepayments which
significantly shorten the average life of mortgage loans and may cause the
Company's repayment experience to differ from that shown below. Loan balances
are net of loans in process. Lease balances are included in other loans.

Due After Due After
1 Through 5 or More
Due One 5 Years After Years After
Year or Less December 31, 2004 December 31, 2004 Total
------------ ----------------- ----------------- -----
(In thousands)

Real estate loans................. $354,291 $142,255 $31,281 $527,827
Commercial........................ 67,241 19,115 707 87,063
Other............................. 8,772 17,661 38 26,471
-------- -------- ------- --------
Total........................ $430,304 $179,031 $32,026 $641,361
======== ======== ======= ========

The following table sets forth at December 31, 2004 the dollar amount of
all loans due one year or more after December 31, 2004 which have predetermined
interest rates and have floating or adjustable interest rates.

Predetermined Floating or
Rates Adjustable Rates
------------- ----------------
(In thousands)

Real estate loans............ $140,184 $33,352
Commercial................... 19,115 707
Other........................ 17,661 38
--------- -------
Total................... $176,960 $34,097
======== =======

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

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

The Bank's loan originations are derived from a number of sources,
including referrals from depositors and borrowers, repeat customers,
advertising, calling officers as well as walk-in customers. The Bank's
solicitation programs consist of advertisements in local media, in addition to
participation in various community organizations and events. Real estate loans
are originated by the Bank's loan personnel. A majority of the Bank's loan
personnel are salaried, and certain mortgage loan officers are paid on a
commission basis based on a percentage of closed mortgage loan volume. With the
exception of applications for boat or recreational vehicle loans, which may be
originated on an indirect basis through an arrangement with dealers, loan
applications are accepted at the Bank's offices. In all cases, the Bank has
final approval of the application. Historically, the Bank generally has not
purchased loans. However, the Bank may in the future consider making limited
loan purchases, including purchases of commercial loans.

5

In recent years, the Bank has sold or exchanged for mortgage-backed
securities a significant amount of fixed-rate, single-family mortgage loans that
it originated. During the years ended December 31, 2004, 2003, and 2002, these
transactions totaled $37.6 million, $136.8 million and $87.2 million,
respectively. Such loans are sold to or exchanged with the Federal Home Loan
Mortgage Corporation ("FHLMC"). The Bank generally retains servicing on loans
sold or exchanged.

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

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

It is the Bank's policy to record a lien on the real estate securing a
loan and to obtain title insurance which insures that the property is free of
prior encumbrances and other possible title defects. Borrowers must also obtain
hazard insurance policies prior to closing and, when the property is in a flood
plain as designated by the Department of Housing and Urban Development, pay
flood insurance policy premiums.

With respect to single-family residential mortgage loans, the Bank makes a
loan commitment of between 15 and 30 days for each loan approved. If the
borrower desires a longer commitment, the commitment may be extended for good
cause and upon written approval. Fees of between $175 and $500 are charged in
connection with the issuance of a commitment letter. The interest rate is
guaranteed for the commitment period.

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

6

The Bank is subject to regulations that limit the amount the Bank can lend
to one borrower. See "-- Depository Institution Regulation -- Limits on Loans to
One Borrower." Under these limits, the Bank's loans-to-one-borrower were limited
to $10.2 million at December 31, 2004. At that date, the Bank had no lending
relationships in excess of the loans-to-one-borrower limit.

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

Single-Family Residential Real Estate Lending. The Bank historically has
been and continues to be an originator of single-family, residential real estate
loans in its market area. At December 31, 2004, single-family, residential
mortgage loans, excluding home improvement loans, totaled $53.1 million, or 7.6%
of the Company's gross loan portfolio.

The Bank originates fixed-rate mortgage loans at competitive interest
rates. At December 31, 2004, $50.5 million, or 64.1%, of the Company's
residential mortgage loan portfolio was comprised of fixed-rate residential
mortgage loans. Generally, the Company retains fixed-rate mortgages with
maturities of 15 years or less while fixed-rate loans with longer maturities may
be retained in portfolio or sold in the secondary market. The Bank also offers
FHA and VA mortgage loans in its market area, which are underwritten, closed and
sold to a correspondent investor.

The Bank also offers adjustable-rate residential mortgage loans. The
adjustable-rate loans currently offered by the Bank have interest rates which
adjust every one, three or five years from the closing date of the loan or on an
annual basis commencing after an initial fixed-rate period of one, three or five
years in accordance with a designated index (the primary index utilized by the
Bank is the weekly average yield on U.S. Treasury securities adjusted to a
constant comparable maturity equal to the loan adjustment period, as made
available by the Federal Reserve Board (the "Treasury Rate")), plus a stipulated
margin. The Bank offers adjustable-rate loans that meet FHLMC standards, as well
as loans that do not meet such standards. The Bank's adjustable-rate
single-family residential real estate loans that do not meet FHLMC standards
have a cap of generally 2% on any increase in the interest rate at any
adjustment date, and include a cap on the maximum interest rate over the life of
the loan, which cap generally is 3% to 4.5% above the initial rate. In return
for providing a relatively low cap on interest rate increases over the life of
the loan, the Bank's adjustable-rate loans provide for a floor on the minimum
interest rate over the life of the loan, which floor generally is the initial
rate. Further, the Bank generally does not offer "teaser" rates, i.e., initial
rates below the fully indexed rate, on such loans. The adjustable-rate mortgage
loans offered by the Bank that do conform to FHLMC standards have a cap of 6%
above the initial rate over the life of a loan but do not include a floor, may
be offered with a teaser rate and have a 25 basis point lower margin above the
index on which the interest rate is based. All of the Bank's adjustable-rate
loans require that any payment adjustment resulting from a change in the
interest rate of an adjustable-rate loan be sufficient to result in full
amortization of the loan by the end of the loan term and, thus, do not permit
any of the increased payment to be added to the principal amount of the loan, or
so-called negative amortization. At December 31, 2004, $28.3 million, or 35.9%,
of the Company's residential mortgage loans were adjustable-rate loans.

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

7

Construction Lending. The Bank also offers residential and commercial
construction loans, with a substantial portion of such loans originated to date
being for the construction of owner-occupied, single-family dwellings in the
Bank's primary market area. Residential construction loans are offered primarily
to individuals building their primary or secondary residence, as well as to
selected local developers to build single-family dwellings. Generally, loans to
owner/occupants for the construction of owner-occupied, single-family
residential properties are originated in connection with the permanent loan on
the property and have a construction term of six to 18 months. Such loans are
offered on a fixed-rate or adjustable-rate basis. Interest rates on residential
construction loans made to the owner/occupant have interest rates during the
construction period of 0.5% or more above the rate offered by the Bank on the
permanent loan product selected by the borrower. Upon completion of
construction, the permanent loan rate will be set at the rate then offered by
the Bank on that permanent loan product, except that if the permanent loan rate
would be above the construction loan rate then the borrower can maintain the
same rate as on the construction loan. Interest rates on residential
construction loans to builders are set at the prime rate plus a margin of
between 0% and 1% or at the Treasury Rate plus a margin of between 3% and 4.5%,
and adjust annually. Interest rates on commercial construction loans are based
on the prime rate plus a negotiated margin of between 0% and 1% and adjust
annually, with construction terms generally not exceeding 18 months. Advances
are made on a percentage of completed basis. At December 31, 2004, $22.7
million, or 3.3%, of the Company's gross loan portfolio consisted of
construction loans, virtually all of which was secured by single-family
residences.

Prior to making a commitment to fund a loan, the Bank requires both an
appraisal of the property by appraisers approved by the Board of Directors and a
study of the feasibility of the proposed project. The Bank also reviews and
inspects each project at the commencement of construction and either weekly or
biweekly during the term of the construction loan. The Bank generally charges a
..50% to 1% construction loan fee for speculative builder loans. For construction
loans to owner-occupants, the Bank generally charges a 1% construction loan fee
and a commitment fee ranging from $275 to $425.

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

Multi-Family Residential and Commercial Real Estate Lending. The Bank
originates commercial real estate loans, as well as a limited amount of
multi-family residential real estate loans, generally limiting such originations
to loans secured by properties in its primary market area and to borrowers with
whom it has other loan relationships. The Company's multi-family residential
loan portfolio consists primarily of loans secured by small apartment buildings,
and the commercial real estate loan portfolio includes loans to finance the
acquisition of small office buildings and commercial and industrial buildings
with a preference to owner occupied. Such loans generally range in size from
$100,000 to $2.0 million. At December 31, 2004, multi-family residential and
commercial real estate loans totaled $3.0 million and $422.6 million,
respectively, which amounted to .4% and 60.5%, respectively, of the Company's
gross loan portfolio. Multi-family and commercial real estate loans are
originated either for three to seven year terms with interest rates that adjust
based on either the prime rate as quoted in The Wall Street Journal plus a
negotiated margin of between 0% and 1% for shorter term loans, or on a
fixed-rate basis with interest calculated on a 20 or 25 year amortization
schedule with a balloon payment due after five years.

8

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

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

In recent years, the Bank has emphasized commercial business lending. The
Bank originates commercial business loans to small and medium sized businesses
in its market area. The Bank's commercial borrowers are generally small
businesses engaged in manufacturing, distribution or retailing, or service
professionals in healthcare, accounting and law. Commercial business loans are
generally made to finance the purchase of inventory, new or used equipment or
commercial vehicles, to support trading assets and for short-term working
capital. Such loans generally are secured by equipment and inventory, and, if
possible, cross-collateralized by a real estate mortgage, although commercial
business loans are sometimes granted on an unsecured basis. Such loans generally
are made for terms of five years or less, depending on the purpose of the loan
and the collateral, with loans to finance operating expenses made for one year
or less, with interest rates that adjust at least annually at a rate equal to
the prime rate as stated in The Wall Street Journal plus a margin of between 0%
and 2%. Generally, commercial loans are made in amounts ranging between $5,000
and $250,000. At December 31, 2004, commercial business loans totaled $87.1
million, or 12.5% of the Company's gross loan portfolio.

The Bank underwrites its commercial business loans on the basis of the
borrower's cash flow and ability to service the debt from earnings rather than
on the basis of underlying collateral value, and the Bank seeks to structure
such loans to have more than one source of repayment. The borrower is required
to provide the Bank with sufficient information to allow the Bank to make its
lending determination. In most instances, this information consists of at least
two years of financial statements, a statement of projected cash flows, current
financial information on any guarantor and any additional information on the
collateral. For loans over $20,000 with maturities exceeding one year, the Bank
generally requires that borrowers and guarantors provide updated financial
information at least annually throughout the term of the loan.

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

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

Consumer Lending. In recent years, the Bank has been successful in its
strategy of increasing its portfolio of consumer loans. The consumer loans
originated by the Bank include automobile loans, certificate of deposit loans,
home equity loans and miscellaneous other consumer loans, including unsecured
loans. At December 31, 2004, consumer loans totaled $98.4 million, or 14.1% of
the Company's gross loan portfolio.

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

9

The Bank makes certificate of deposit loans for up to 95% of the
depositor's account balance. The interest rate is normally 2% above the annual
percentage yield paid on the account and the account must be pledged as
collateral to secure the loan. Interest generally is billed on a quarterly
basis. At December 31, 2004, loans on certificates of deposit totaled $1.4
million, or .2% of the Company's gross loan portfolio.

At December 31, 2004, the Company had approximately $42.3 million in home
equity line of credit loans, representing approximately 6.1% of its gross loan
portfolio. The Company's home equity lines of credit have adjustable interest
rates tied to the prime interest rate plus a margin. The home equity lines of
credit require monthly payments until the loan is paid in full. Home equity
lines of credit are generally secured by subordinate liens against residential
real property. The Bank requires that fire and extended coverage casualty
insurance (and, if appropriate, flood insurance) be maintained in an amount at
least sufficient to cover its loan. Home equity loans are generally limited so
that the amount of such loans, along with any senior indebtedness, does not
exceed 85% of the value of the real estate security.

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

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

In addition, the Bank has developed a program to originate loans for a
local credit union. The Bank receives a $600 origination fee for each loan as
well as an annual servicing fee of .375% of the loan amount. All of these loans
are funded and closed in the name of the credit union. The Bank has explored the
possibility of developing similar arrangements with other institutions, although
none are currently planned.

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

Loans generally are placed on nonaccrual status, and accrued but unpaid
interest is reversed, when, in management's judgment, it is determined that the
collectibility of interest, but not necessarily principal, is doubtful.
Generally, this occurs when payment is delinquent in excess of 90 days. Consumer
loans are generally charged off, or any expected loss is reserved for, after
they become more than 120 days past due. All other loans are charged off when
management concludes that they are uncollectible. See Note 4 of Notes to
Consolidated Financial Statements for the Year Ended December 31, 2004.

10

Real estate acquired by the Bank as a result of foreclosure is classified
as real estate acquired through foreclosure until such time as it is sold and is
recorded at the lower of the estimated fair value of the underlying real estate
or the carrying amount of the loan. Costs relating to holding or improving such
real estate are charged against income in the current period. Any required
write-down of the loan to its fair value less estimated selling costs upon
foreclosure is charged against the allowance for loan losses. See Note 4 of
Notes to Consolidated Financial Statements for the Year Ended December 31, 2004.

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

At December 31 At September 30,
--------------------------------------------- -------------------
2004 2003 2002 2001 2001 2000
------- -------- -------- ------- ------- ------
(Dollars in thousands)

Loans accounted for on a nonaccrual basis:
Residential mortgage:
Single-family............................ $ 814 $ 1,057 $ 460 $ 864 $ 570 $1,110
Construction............................. -- -- 143 -- -- 258
Commercial real estate..................... 1,241 1,334 427 200 132 --
Commercial business........................ 49 19 219 83 228 139
Consumer................................... 245 215 247 106 132 139
------- -------- -------- ------- ------- ------
Total nonperforming loans................ $2,349 $ 2,625 $ 1,496 $ 1,253 $ 1,062 $1,646
====== ======== ======== ======= ======= ======
Percentage of total loans, net............... .37% .47% .30% .31% .28% .45%
======= ======== ======== ======= ======= ======
Real estate owned............................ 89 131 402 677 530 220
======= ======== ======== ======= ======= ======

During the year ended December 31, 2004, additional gross interest income
of approximately $122,000 would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current throughout this period. Interest
on such loans included in income during the period amounted to approximately
$15,000.

At December 31, 2004, the Bank had no loans not classified as nonaccrual,
90 days past due or restructured loans where known information about possible
credit problems of borrowers caused management to have serious concerns as to
the ability of the borrowers to comply with present loan repayment terms and may
result in disclosure as nonaccrual, 90 days past due or restructured.

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

At December 31, 2004, an analysis of the Bank's portfolio did not reveal
any impaired loans that needed to be classified under SFAS No. 114 or 118. A
loan is considered impaired, based on current information and events, if it is
probable that the Bank will be unable to collect the scheduled payments of
principal and interest when due according to the contractual terms of the loan
arrangement. Uncollateralized loans are measured for impairment based on the
present value of expected future cash flows discounted at the historical
effective interest rate, while all collateral dependent loans are measured for
impairment based on the fair value of the collateral. The Bank uses several
factors in determining if a loan is impaired. The internal asset classification
procedures include a thorough review of significant loans and lending
relationships and include the accumulation of related data. This data includes
loan payments status, borrowers' financial data and borrowers' operating factors
such as cash flows, operating income or loss, and various other matters.

At December 31, 2004, the Company had $2.3 million of nonaccrual loans,
which consisted of 18 single-family residential real estate loans totaling
$814,000, three commercial real estate loans totaling $1.2 million, three
commercial business loans totaling $49,000 and 21 consumer loans totaling
$245,000.

At December 31, 2004, the Bank had $89,000 of real estate owned, which
consisted of three single-family residences.

11

Classified Assets. Federal regulations require that the Bank classify its
assets on a regular basis. In addition, in connection with examinations of
insured institutions, examiners have authority to identify problem assets and if
appropriate, classify them in their reports of examination. There are four
classifications for problem assets: "special mention," "substandard," "doubtful"
and "loss." Special mention assets contain some weakness as defined under the
substandard category, but do not contain the risk level associated with an
adverse classification. Special mention assets are noted for a watch list to
indicate that a potential weakness or risk exists, which could cause a more
serious problem if not corrected. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the insured
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of substandard assets with the additional
characteristic that the weaknesses make collection or liquidation in full, on
the basis of currently existing facts, conditions and values, questionable, and
there is a high possibility of loss. An asset classified loss is considered
uncollectible and of such little value that continuance as an asset of the
institution is not warranted. Assets classified as substandard or doubtful
require a bank to establish general allowances for loan losses. If an asset or
portion thereof is classified loss, a bank must either establish a specific
allowance for loss in the amount of the portion of the asset classified loss, or
charge off such amount. The Bank regularly reviews its assets to determine
whether any assets require classification or re-classification. At December 31,
2004, the Company had $19.1 million in classified assets, including $10.8
million in assets classified as special mention, $7.9 million in assets
classified as substandard, $62,000 in assets classified as doubtful and $251,000
in assets classified as loss.

Allowance for Loan Losses. The Company's policy is to establish reserves
for estimated probable losses on delinquent loans when it determines that losses
are expected to be incurred on such loans. The allowance for losses on loans is
maintained at a level believed adequate by management to absorb probable losses
in the portfolio. Management's determination of the adequacy of the allowance is
based on an evaluation of the portfolio, past loss experience, current economic
conditions, volume, growth and composition of the portfolio, and other relevant
factors. The allowance is increased by provisions for loan losses which are
charged against income.

Although management believes it uses the best information available to
make determinations with respect to the allowances for losses and believes such
allowances are adequate, future adjustments may be necessary if economic
conditions differ substantially from the economic conditions in the assumptions
used in making the initial determinations. Management anticipates that the
Company's allowance for loan losses will increase in the future as it implements
the Board of Directors' strategy of continuing existing lines of business while
gradually expanding commercial business and consumer lending, which loans
generally entail greater risks than single-family residential mortgage loans.

12

The following table sets forth an analysis of the Company's allowance for
loan losses for the periods indicated.

Year Ended Three Months Year Ended
December 31, Ended September 30,
------------------------------ December 31, ------------------
2004 2003 2002 2001 2001 2000
------ ------ ------ ------ ------ ------
(Dollars in thousands)

Balance at beginning of period......... $7,634 $6,959 $5,371 $5,401 $5,159 $3,297
------ ------ ------ ------ ------ ------
Loans charged-off:
Commercial business.................... 55 125 60 -- 423 58
Consumer............................. 247 232 133 42 233 99
------ ------ ------ ------ ------ ------
Total charge-offs................ 302 358 193 42 656 157
====== ====== ====== ====== ====== ======

Recoveries:
Residential real estate mortgage:
Single-family residential.......... 4 -- -- -- -- --
Commercial........................... 2 24 11 2 49 70
Consumer............................. 37 21 14 10 19 9
------ ------ ------ ------ ------ ------
Total recoveries................. 43 45 25 12 68 79
------ ------ ------ ------ ------ ------
Net loans charged-off.................. 259 313 168 30 588 78
------ ------ ------ ------ ------ ------

Additions:
Balance transferred in acquisition..... -- -- -- -- -- 963
Provision for loan losses.............. 968 988 1,756 -- 830 977
------ ------ ------ ------ ------ ------
Total additions.................. 968 988 1,756 -- 830 1,940
------ ------ ------ ------ ------ ------
Balance at end of period............... $8,343 $7,634 $6,959 $5,371 $5,401 $5,159
====== ====== ====== ====== ====== ======
Ratio of net charge-offs to average
loans outstanding during the period.. .04% .06% .04% .01% .16% .02%
====== ====== ====== ====== ====== ======

13

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

At December 31, At September 30,
------------------------------------------------------------------- ------------------------------------
2004 2003 2002 2001 2001 2001
---------------- --------------- ---------------- ----------------- ---------------- -------------------
Percent of Percent of Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in Loans in Loans in
Category to Category to Category to Category to Category to Category to
Total Total Total Total Total Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
------ ----- ------ ----- ------ ----- ------ ----- ------ ----- ------ -----
(Dollars in thousands)

Residential mortgage..... $1,034 11.3% $ 1,034 13.1% $ 1,034 24.0% $ 1,034 33.1% $ 1,034 33.5% $ 1,034 43.7%
Commercial (1)........... 6,362 74.6 5,487 71.9 4,726 60.6 3,243 48.7 3,241 46.8 3,125 37.2
Consumer................. 947 14.1 1,113 15.0 1,199 15.4 1,094 18.2 1,126 19.7 1,000 19.1
------ ----- ------- ----- -------- ----- -------- ----- ------- ----- ------- -----
Total allowance for
loan losses........ $8,343 100.0% $ 7,634 100.0% $ 6,959 100.0% $ 5,371 100.0% $ 5,401 100.0% $ 5,159 100.0%
====== ===== ======= ===== ======== ===== ======== ===== ======= ===== ======= =====

- ---------------

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

14

Investment Activities

General. Interest income from mortgage-backed securities and investment
securities generally provides the second largest source of income to the Company
after interest on loans. The Bank's Board of Directors has authorized investment
in U.S. Government and agency securities, state government obligations,
municipal securities, obligations of the Federal Home Loan Bank ("FHLB") and
mortgage-backed securities. The Bank's objective is to use such investments to
reduce interest rate risk, enhance yields on assets and provide liquidity. At
December 31, 2004, the Company's mortgage-backed securities and investment
securities portfolio amounted to $9.2 million and $32.1 million, respectively.
At such date, the Company had an unrealized gain of $695,000, net of deferred
taxes, with respect to its securities.

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

Mortgage-Backed Securities. At December 31, 2004, the Company's
mortgage-backed securities amounted to $9.2 million, or 1.3% of total assets.
Mortgage-backed securities represent a participation interest in a pool of
single-family or multi-family mortgages, the principal and interest payments on
which are passed from the mortgage originators through intermediaries that pool
and repackage the participation interest in the form of securities to investors
such as the Bank. Such intermediaries may include quasi-governmental agencies
such as FHLMC, FNMA and GNMA which guarantee the payment of principal and
interest to investors. Mortgage-backed securities generally increase the quality
of the Bank's assets by virtue of the guarantees that back them, are more liquid
than individual mortgage loans and may be used to collateralize borrowings or
other obligations of the Bank. At December 31, 2004, all of the Company's
mortgage-backed securities were backed by loans originated by the Bank and
swapped with the FHLMC in exchange for such mortgage-backed securities.

The FHLMC is a public corporation chartered by the U.S. Government and
owned by the 12 FHLBs and federally insured savings institutions. The FHLMC
issues participation certificates backed principally by conventional mortgage
loans. The FHLMC guarantees the timely payment of interest and the ultimate
return of principal on participation certificates. FHLMC securities are not
backed by the full faith and credit of the United States, however, these
securities are considered to be among the highest quality investments with
minimal credit risks. The maximum loan limit for FNMA and FHLMC currently is
$359,650.

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

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

15

At December 31, 2004, mortgage-backed securities with an amortized cost of
$6.3 million and a carrying value of $6.6 million were held as available for
sale, and mortgage-backed securities with an amortized cost of $2.6 million and
a carrying value of $2.6 million were held for investment. Mortgage-backed
securities which are held to maturity are carried at cost, adjusted for the
amortization of premiums and the accretion of discounts using a method which
approximates a level yield. Mortgage-backed securities classified as available
for sale are carried at fair value. Unrealized gains and losses on available for
sale mortgage-backed securities are recognized as direct increases or decreases
in equity, net of applicable income taxes. See Notes 1, 2 and 3 of the Notes to
Consolidated Financial Statements in the Annual Report. At December 31, 2004,
the Bank's mortgage-backed securities had a weighted average yield of 6.32%.

At December 31, 2004, the average contractual maturity of the Company's
fixed-rate mortgage-backed securities was approximately 8.9 years. The actual
maturity of a mortgage-backed security varies, depending on when the mortgagors
prepay or repay the underlying mortgages. Prepayments of the underlying
mortgages may shorten the life of the investment, thereby adversely affecting
its yield to maturity and the related market value of the mortgage-backed
security. The yield is based upon the interest income and the amortization of
the premium or accretion of the discount related to the mortgage-backed
security. Premiums and discounts on mortgage-backed securities are amortized or
accreted over the estimated term of the securities using a level yield method.
The prepayment assumptions used to determine the amortization period for
premiums and discounts can significantly affect the yield of the mortgage-backed
security, and these assumptions are reviewed periodically to reflect the actual
prepayment. The actual prepayments of the underlying mortgages depend on many
factors, including the type of mortgage, the coupon rate, the age of the
mortgages, the geographical location of the underlying real estate
collateralizing the mortgages and general levels of market interest rates. The
difference between the interest rates on the underlying mortgages and the
prevailing mortgage interest rates is an important determinant in the rate of
prepayments. During periods of falling mortgage interest rates, prepayments
generally increase, and, conversely, during periods of rising mortgage interest
rates, prepayments generally decrease. If the coupon rate of the underlying
mortgage significantly exceeds the prevailing market interest rates offered for
mortgage loans, refinancing generally increases and accelerates the prepayment
of the underlying mortgages. Prepayment experience is more difficult to estimate
for adjustable-rate mortgage-backed securities.

Investment Securities. The Company's investment securities consist
primarily of securities issued by the U.S. government and government agencies.
At December 31, 2004, the Company's entire portfolio of investment securities
was classified available for sale and amounted to $32.0 million. The Company
attempts to maintain a high degree of liquidity in its investment securities
portfolio by choosing those that are readily marketable. As of December 31,
2004, the estimated average life of the Company's investment securities
portfolio was approximately 1.1 years. In addition, at December 31, 2004, the
Company had $1.8 million of FHLB stock.

16

The following table sets forth the scheduled maturities, carrying values,
amortized cost and average yields for the Company's investment securities and
mortgage-backed securities portfolio at December 31, 2004.

One Year One to Five to More than Total
or Less Five Years Ten Years Ten Years Investment Portfolio
---------------- ---------------- ---------------- ---------------- -------------------------
Carrying Average Carrying Average Carrying Average Carrying Average Carrying Amortized Average
Value Yield Value Yield Value Yield Value Yield Value Cost Yield
------- ------ ------- ------ ------- ------ ------- ------ ------- ------- ------
(Dollars in thousands)

Securities available
for sale:
U.S. government and
agency securities ...... $16,246 7.09% $15,812 6.56% $ -- --% $ -- --% $32,058 $30,956 6.83%
Mortgage-backed
securities ............. -- -- 552 6.44 5,914 6.26 173 8.11 6,639 6,320 6.32
Securities held to maturity:
FHLB stock (1) .......... -- -- -- -- -- -- 1,825 3.75 1,825 1,825 3.75
Mortgaged-backed
securities .............. -- -- -- -- 2,569 4.00 -- -- 2,569 2,569 4.00
------- ------ ------- ------ ------- ------ ------- ------ ------- ------- ------
Total ...................... $16,246 7.09% $16,364 6.56% $ 8,483 5.58% $ 1,998 4.13% $43,091 $41,670 6.45%
======= ====== ======= ====== ======= ====== ======= ====== ======= ======= ======

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

17

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

At December 31,
---------------------------
2004 2003 2002
------ ------ ------
(In thousands)
Securities available for sale:
U.S. government and agency securities $32,058 $50,072 $55,787
Mortgage-backed securities .......... 6,639 11,715 23,526
------- ------- -------
Total ............................ $38,697 $61,787 $79,313
======= ======= =======

Securities held to maturity:
FHLB stock .......................... 1,825 2,127 2,403
Mortgage-backed securities .......... 2,569 -- --
------- ------- -------
Total ............................ $ 4,394 $63,914 $81,716
======= ======= =======

Deposit Activity and Other Sources of Funds

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

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

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

18

The following tables set forth the distribution of the Bank's deposit
accounts at the dates indicated, the weighted average interest rates and the
change in dollar amounts for each category of deposits presented. Management
does not believe that the use of year-end balances instead of average balances
resulted in any material difference in the information presented.

As of and for the
Year Ended December 31,
-------------------------------------------------------------------------------
2004 2003 2002
------------------------ --------------------- ------------------------
Weighted Weighted Weighted
Average Average Average
Amount Rate Amount Rate Amount Rate
----------- -------- ----------- -------- ---------- ---------
(Dollars in thousands)

Demand accounts:
Checking $ 215,349 .45% $202,627 .49% $ 167,307 .83%
Money market 20,971 .72 25,237 .69 32,309 1.14
Savings accounts 22,018 .15 20,292 .15 8,950 .25
----------- ---- -------- ---- ---------- ----
Total $ 258,338 .45% $248,156 .48% $218,566 .82%
=========== ==== ======== ==== ========== ====

Certificate accounts:
Less than 12 months (1) $ 86,133 1.77% $139,312 1.82% $ 44,547 1.69%
12 - 14 months (1) 98,958 2.15 91,481 1.70 159,019 2.71
15 - 72 months (1) 185,107 2.89 104,224 3.06 104,195 3.82
----------- ---- -------- ---- ---------- ----
Total 370,198 2.43 335,017 2.18 307,761 2.94
----------- ---- -------- ---- ---------- ----
Total deposits $ 628,536 1.62% $583,173 1.46% $ 526,327 2.06%
=========== ==== ======== ==== ========== ====

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

The following table indicates the amount (in thousands) of the Company's
certificates of deposit of $100,000 or more by time remaining until maturity as
of December 31, 2004. At such date, such deposits represented 19.2% of total
deposits and had a weighted average rate of 2.41%.

Maturity Period
---------------
(In thousands)

Three months or less....................... $ 9,235
Over three through six months.............. 6,515
Over six through 12 months................. 46,389
Over 12 months............................. 58,618
----------
Total................................ $ 120,757
==========

At December 31, 2004, U.S. Agency Bonds with an amortized cost of $13.0
million were pledged as collateral for deposits from public entities.

Borrowings. Savings deposits historically have been the primary source of
funds for the Bank's lending, investment and general operating activities. The
Bank is authorized, however, to use advances from the FHLB of Atlanta to
supplement its supply of lendable funds and to meet deposit withdrawal
requirements. The FHLB of Atlanta functions as a central reserve bank providing
credit for savings institutions and certain other member financial institutions.
As a member of the FHLB System, the Bank is required to own stock in the FHLB of
Atlanta and is authorized to apply for advances. Advances are pursuant to
several different programs, each of which has its own interest rate and range of
maturities. The FHLB capital stock requirement is based on the sum of a
membership stock component totaling .20% of the Bank's total assets plus an
activity-based stock component of 4.5% of outstanding FHLB advances. Advances
from the FHLB of Atlanta are secured by the Bank's stock in the FHLB of Atlanta
and other eligible assets. During the years ended December 31, 2004, 2003 and
2002, the three months ended December 31, 2001 and the year ended September 30,
2001, the Bank's borrowings consisted of FHLB advances and retail repurchase
agreements. Retail repurchase agreements represent agreements to sell securities
under terms which require the Bank to repurchase the same or substantially
similar securities by a specified date.

19

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

At or for the
Year Ended December 31,
---------------------------------
2004 2003 2002
--------- ------- ---------
(In thousands)

Amounts outstanding at end of period:
FHLB advances ................................... $10,500 $16,000 $34,000
Federal funds purchased and securities
sold under repurchase agreements .............. 4,292 3,338 4,195
Weighted average rate paid on:
FHLB advances ................................... 2.44% 1.38% 1.30%
Federal funds purchased and securities sold under
agreements to repurchase ...................... 1.62% .58% .53%
Maximum amount of borrowings outstanding
at any month end:
FHLB advances ................................... 46,500 19,000 34,000
Federal funds purchased and securities
sold under repurchase agreements .............. 4,960 6,872 5,073
Approximate average short-term borrowings
outstanding with respect to:
FHLB advances ................................... 19,108 6,240 1,469
Federal funds purchased and securities
sold under repurchase agreements .............. 4,019 4,674 4,344
Approximate weighted average rate paid on: (1)
FHLB advances ................................... 1.46% 1.38% 1.90%
Federal funds purchased and securities
sold under repurchase agreements .............. .92% .60% .94%

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

Competition

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

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

20

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

Employees

As of December 31, 2004, the Bank had 235 full-time and 32 part-time
employees, none of whom were represented by a collective bargaining agreement.
Management considers the Bank's relationships with its employees to be good.

Depository Institution Regulation

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

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

The system of regulation and supervision applicable to the Bank
establishes a comprehensive framework for the operations of the Bank, and is
intended primarily for the protection of the FDIC and the depositors of the
Bank. Changes in the regulatory framework could have a material effect on the
Bank that in turn, could have a material effect on the Company.

Financial Modernization Legislation. On November 12, 1999, legislation was
enacted which could have a far-reaching impact on the financial services
industry. The Gramm-Leach-Bliley ("G-L-B") Act authorizes affiliations between
banking, securities and insurance firms and authorizes bank holding companies
and national banks to engage in a variety of new financial activities. Among the
new activities that will be permitted to bank holding companies are securities
and insurance brokerage, securities underwriting, insurance underwriting and
merchant banking. The Federal Reserve Board, in consultation with the Secretary
of the Treasury, may approve additional financial activities. The G-L-B Act,
however, prohibits future acquisitions of existing unitary savings and loan
holding companies by firms which are engaged in commercial activities and limits
the permissible activities of unitary savings and loan holding companies formed
after May 4, 1999.

The G-L-B Act imposes new requirements on financial institutions with
respect to customer privacy. The G-L-B Act generally prohibits disclosure of
customer information to nonaffiliated third parties unless the customer has been
given the opportunity to object and has not objected to such disclosure.
Financial institutions are further required to disclose their privacy policies
to customers annually. Financial institutions, however, will be required to
comply with state law if it is more protective of customer privacy than the
G-L-B Act. The G-L-B Act directs the federal banking agencies, the National
Credit Union Administration, the Secretary of the Treasury, the Securities and
Exchange Commission and the Federal Trade Commission, after consultation with
the National Association of Insurance Commissioners, to promulgate implementing
regulations within six months of enactment. The privacy provisions became
effective in July 2001.

The G-L-B Act contains significant revisions to the FHLB System. The G-L-B
Act imposes new capital requirements on the FHLBs and authorizes them to issue
two classes of stock with differing dividend rates and redemption requirements.
The G-L-B Act deletes the current requirement that the FHLBs annually contribute
$300 million to pay interest on certain government obligations in favor of a 20%
of net earnings formula. The G-L-B Act expands the permissible uses of FHLB
advances by community financial institutions (under $500 million in assets) to
include funding loans to small businesses, small farms and small
agri-businesses. The G-L-B Act makes membership in the FHLB voluntary for
federal savings associations.

21

The G-L-B Act contains a variety of other provisions including a
prohibition against ATM surcharges unless the customer has first been provided
notice of the imposition and amount of the fee. The G-L-B Act reduces the
frequency of Community Reinvestment Act examinations for smaller institutions
and imposes certain reporting requirements on depository institutions that make
payments to nongovernmental entities in connection with the Community
Reinvestment Act. The G-L-B Act eliminates the SAIF special reserve and
authorizes a federal savings association that converts to a national or state
bank charter to continue to use the term "federal" in its name and to retain any
interstate branches.

The Company is unable to predict the impact of the G-L-B Act on its
operations at this time.

Capital Requirements. The Federal Reserve Board and the FDIC have
established guidelines with respect to the maintenance of appropriate levels of
capital by bank holding companies with consolidated assets of $150 million or
more and state nonmember banks, respectively. The regulations impose two sets of
capital adequacy requirements: minimum leverage rules, which require bank
holding companies and state nonmember banks to maintain a specified minimum
ratio of capital to total assets, and risk-based capital rules, which require
the maintenance of specified minimum ratios of capital to "risk-weighted"
assets. The regulations of the FDIC and the Federal Reserve Board require bank
holding companies and state nonmember banks, respectively, to maintain a minimum
leverage ratio of "Tier 1 capital" to total assets of 3.0%. Although setting a
minimum 3.0% leverage ratio, the capital regulations state that only the
strongest bank holding companies and banks, with composite examination ratings
of 1 CAMELS under the rating system used by the federal bank regulators, are
permitted to operate at or near such minimum level of capital. All other bank
holding companies and banks must maintain a leverage ratio of at least 4%. Tier
1 capital is the sum of common stockholders' equity, noncumulative perpetual
preferred stock (including any related surplus), and minority interests in
consolidated subsidiaries; minus all intangible assets (other than certain
purchased mortgage servicing rights and purchased credit card receivables),
identified losses and investments in certain subsidiaries. As a SAIF-insured,
state-chartered bank, the Bank must also deduct from Tier 1 capital an amount
equal to its investments in, and extensions of credit to, subsidiaries engaged
in activities that are not permissible for national banks, other than debt and
equity investments in subsidiaries engaged in activities undertaken as agent for
customers or in mortgage banking activities or in subsidiary depository
institutions or their holding companies. Any bank or bank holding companies
experiencing or anticipating significant growth would be expected to maintain
capital well above the minimum levels. In addition, the Federal Reserve Board
has indicated that whenever appropriate, and in particular when a bank holding
company is undertaking expansion, seeking to engage in new activities or
otherwise facing unusual or abnormal risks, it will consider, on a case-by-case
basis, the level of an organization's ratio of tangible Tier 1 capital to total
assets in making an overall assessment of capital.

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

22

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

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

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

Adequately Significantly
Well Capitalized Capitalized Undercapitalized Undercapitalized
---------------- ----------- ---------------- ----------------

Total risk-based
capital ratio 10.0% or more 8.0% or more Less than 8.0% Less than 6.0%
Tier 1 risk-based
capital ratio 6.0% or more 4.0% or more Less than 4.0% Less than 3.0%
Leverage ratio 5.0% or more 4.0% or more * Less than 4.0% * Less than 3.0%

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

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

23

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

Community Reinvestment Act. The Bank, like other financial institutions,
is subject to the Community Reinvestment Act ("CRA"). The purpose of the CRA is
to encourage financial institutions to help meet the credit needs of their
entire communities, including the needs of low-and moderate-income
neighborhoods. During the Bank's last compliance examination, the Bank received
a satisfactory rating with respect to CRA compliance.

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

The Bank's CRA rating would be a factor to be considered by the Federal
Reserve Board and the FDIC in considering applications submitted by the Bank to
acquire branches or to acquire or combine with other financial institutions and
take other actions and, if such rating was less than "satisfactory," could
result in the denial of such applications.

Federal Home Loan Bank System. The FHLB System consists of 12 district
FHLBs subject to supervision and regulation by the Federal Housing Finance Board
("FHFB"). The FHLBs provide a central credit facility primarily for member
institutions. As a member of the FHLB of Atlanta, the Bank is required to
acquire and hold shares of capital stock in the FHLB of Atlanta based on the sum
of a membership stock component totaling .20% of the Bank's total assets plus an
activity-based stock component of 4.5% of outstanding FHLB advances. . The Bank
was in compliance with this requirement with investment in FHLB of Atlanta stock
at December 31, 2004, of $1.8 million. The FHLB of Atlanta serves as a reserve
or central bank for its member institutions within its assigned district. It is
funded primarily from proceeds derived from the sale of consolidated obligations
of the FHLB System. It offers advances to members in accordance with policies
and procedures established by the FHFB and the Board of Directors of the FHLB of
Atlanta. Long-term advances may only be made for the purpose of providing funds
for residential housing finance, small businesses, small farms and small
agribusinesses.

Reserves. Pursuant to regulations of the Federal Reserve Board, the Bank
must maintain average daily reserves equal to 3% on transaction accounts of $6.0
million up to $42.1 million, plus 10% on the remainder. This percentage is
subject to adjustment by the Federal Reserve Board. Because required reserves
must be maintained in the form of vault cash or in a noninterest bearing account
at a Federal Reserve Bank, the effect of the reserve requirement is to reduce
the amount of the institution's interest-earning assets. As of December 31,
2004, the Bank met its reserve requirements.

24

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

Deposit Insurance. The Bank is required to pay assessments based on a
percentage of its insured deposits to the FDIC for insurance of its deposits by
the SAIF. Under the FDIC's risk-based deposit insurance assessment system, the
assessment rate for an insured depository institution depends on the assessment
risk classification assigned to the institution by the FDIC, which is determined
by the institution's capital level and supervisory evaluations. Based on the
data reported to regulators for the date closest to the last day of the seventh
month preceding the semi-annual assessment period, institutions are assigned to
one of three capital groups -- well capitalized, adequately capitalized or
undercapitalized -- using the same percentage criteria as in the prompt
corrective action regulations. See "-- Prompt Corrective Regulatory Action."
Within each capital group, institutions are assigned to one of three subgroups
on the basis of supervisory evaluations by the institution's primary supervisory
authority and such other information as the FDIC determines to be relevant to
the institution's financial condition and the risk posed to the deposit
insurance fund. Subgroup A consists of financially sound institutions with only
a few minor weaknesses. Subgroup B consists of institutions that demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the institution and increased risk of loss to the deposit insurance fund.
Subgroup C consists of institutions that pose a substantial probability of loss
to the deposit insurance fund unless effective corrective action is taken.

The assessment rate for SAIF members ranges from zero for well capitalized
institutions in Subgroup A to 0.27% of deposits for undercapitalized
institutions in Subgroup C. Both BIF and SAIF members are assessed an amount for
Financing Corporation bond payments. Until December 31, 1999, BIF members were
assessed approximately 1.3 basis points while the SAIF rate was approximately
6.4 basis points. As of January 1, 2000, BIF and SAIF members began pro rata
sharing of the payment at a rate of 2.43 basis points.

Liquidity Requirements. FDIC policy requires that banks maintain an
average daily balance of liquid assets (cash, certain time deposits,
mortgage-backed securities, loans available for sale and specified United States
government, state, or federal agency obligations) in an amount which it deems
adequate to protect safety and soundness of the bank. The FDIC currently has no
specific level which it requires. Under the FDIC's calculation method,
management calculated the Bank's liquidity ratio as 8.6% of total deposits at
December 31, 2004, which management believes is adequate.

Dividend Restrictions. Under FDIC regulations, the Bank is prohibited from
making any capital distributions if after making the distribution, the Bank
would have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier
1 risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less
than 4.0%.

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

Limits on Loans to One Borrower. The Bank generally is subject to both
FDIC regulations and North Carolina law regarding loans to any one borrower,
including related entities. Under applicable law, with certain limited
exceptions, loans and extensions of credit by a state chartered nonmember bank
to a person outstanding at one time and not fully secured by collateral having a
market value at least equal to the amount of the loan or extension of credit
shall not exceed 15% of the unimpaired capital of the Bank. Loans and extensions
of credit fully secured by readily marketable collateral having a market value
shall not exceed 10% of the unimpaired capital fund of the Bank. Under these
limits, the Bank's loans to one borrower were limited to $11.3 million at
December 31, 2004. At that date, the Bank had no lending relationships in excess
of the loans-to-one-borrower limit. Notwithstanding the statutory
loans-to-one-borrower limitations, the Bank has a self imposed
loans-to-one-borrower limit, which currently is $5.5 million, which it has
exceeded from time to time as approved in advance by the Board of Directors. At
December 31, 2004, the Bank's largest lending relationship was a $5.8 million
relationship consisting of two commercial real estate loans. All loans within
this relationship were current and performing in accordance with their terms at
December 31, 2004.

25

Transactions with Related Parties. Transactions between a state nonmember
bank and any affiliate are governed by Sections 23A and 23B of the Federal
Reserve Act. An affiliate of a state nonmember bank is any company or entity
which controls, is controlled by or is under common control with the state
nonmember bank. In a holding company context, the parent holding company of a
state nonmember bank (such as the Company) and any companies which are
controlled by such parent holding company are affiliates of the savings
institution or state nonmember bank. Generally, Sections 23A and 23B (i) limit
the extent to which an institution or its subsidiaries may engage in "covered
transactions" with any one affiliate to an amount equal to 10% of such
institution's capital stock and surplus, and contain an aggregate limit on all
such transactions with all affiliates to an amount equal to 20% of such capital
stock and surplus and (ii) require that all such transactions be on terms
substantially the same, or at least as favorable, to the institution or
subsidiary as those provided to a non-affiliate. The term "covered transaction"
includes the making of loans, purchase of assets, issuance of a guarantee and
similar other types of transactions. In addition to the restrictions imposed by
Sections 23A and 23B, no state nonmember bank may (i) loan or otherwise extend
credit to an affiliate, except for any affiliate which engages only in
activities which are permissible for bank holding companies, or (ii) purchase or
invest in any stocks, bonds, debentures, notes or similar obligations of any
affiliate, except for affiliates which are subsidiaries of the state nonmember
bank.

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

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

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

26

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

The FDIC has adopted regulations to clarify the foregoing restrictions on
activities of FDIC-insured state-chartered banks and their subsidiaries. Under
the regulations, the term "activity" refers to the conduct of business by an
insured state bank and includes acquiring or retaining an equity or other
investment as defined by regulation. An activity permissible for a national bank
includes any activity expressly authorized for national banks by statute or
recognized as permissible in regulations, official circulars, bulletins, orders
or written interpretations issued by the Office of the Comptroller of the
Currency. In its regulations, the FDIC indicates that it will not permit state
banks to directly engage in commercial ventures or directly or indirectly engage
in any insurance underwriting activity other than to the extent such activities
are permissible for a national bank or a national bank subsidiary or except for
certain other limited forms of insurance underwriting permitted under the
regulations. Further, the FDIC regulations permit state banks that meet
applicable minimum capital requirements to engage as principal in certain
activities that are not permissible to national banks including guaranteeing
obligations of others, activities which the Federal Reserve Board has found by
regulation or order to be closely related to banking and certain securities
activities conducted through subsidiaries.

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

Regulation of the Company

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

Under the BHCA, a bank holding company must obtain Federal Reserve Board
approval before: (i) acquiring, directly or indirectly, ownership or control of
any voting shares of another bank or bank holding company if, after such
acquisition, it would own or control more than 5% of such shares (unless it
already owns or controls the majority of such shares); (ii) acquiring all or
substantially all of the assets of another bank or bank holding company; or
(iii) merging or consolidating with another bank holding company, (satisfactory
financial condition, particularly with respect to capital adequacy, and a
satisfactory CRA rating generally are prerequisites to obtaining federal
regulatory approval to make acquisitions).

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

27

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

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

Interstate Banking. The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 (the "Riegle Act") was enacted to ease restrictions on
interstate banking. Effective September 29, 1995, the Riegle Act allows the
Federal Reserve Board to approve an application of an adequately capitalized and
adequately managed bank holding company to acquire control of, or acquire all or
substantially all of the assets of, a bank located in a state other than the
holding company's home state, without regard to whether the transaction is
prohibited by the laws of any state. The Federal Reserve Board may not approve
the acquisition of a bank that has not been in existence for a minimum of five
years without regard for a longer minimum period specified by the law of the
host state. The Riegle Act also prohibits the Federal Reserve Board from
approving an application if the applicant (and its depository institution
affiliates) controls or would control (i) more than 10% of the insured deposits
in the United States, or (ii) 30% or more of the deposits in the target bank's
home state or in any state in which the target bank maintains a branch. The
Riegle Act does not affect a state's authority to limit the percentage of total
insured deposits in the state which may be held or controlled by a bank or bank
holding company to the extent such limitation does not discriminate against
out-of-state banks or bank holding companies. Individual states may also waive
the 30% state-wide concentration limit contained in the Riegle Act.

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

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

28

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

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

Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of
2002 ("SOX") was signed into law which mandated a variety of reforms intended to
address corporate and accounting fraud. SOX contained provisions which amend the
Securities Exchange Act of 1934, as amended (the "Act") and provisions which
directed the SEC to promulgate rules. The resultant law and regulations under
the Act as of the time of this annual report is set forth in the following
paragraphs. SOX provides for the establishment of a new Public Company
Accounting Oversight Board ("PCAOB"), which will enforce auditing, quality
control and independence standards for firms that audit Securities and Exchange
Commission ("SEC")-reporting companies and will be funded by fees from all
SEC-reporting companies. SOX imposed higher standards for auditor independence
and restricts provision of consulting services by auditing firms to companies
they audit. Any non-audit services being provided to an audit client will
require preapproval by the Company's audit committee members. In addition,
certain audit partners must be rotated periodically. SOX requires chief
executive officers and chief financial officers, or their equivalent, to certify
to the accuracy of periodic reports filed with the SEC, subject to civil and
criminal penalties if they knowingly or willfully violate this certification
requirement. In addition, under SOX, counsel will be required to report evidence
of a material violation of the securities laws or a breach of fiduciary duty by
a company to its chief executive officer or its chief legal officer, and, if
such officer does not appropriately respond, to report such evidence to the
audit committee or other similar committee of the board of directors or the
board itself.

Longer prison terms will also be applied to corporate executives who
violate federal securities laws, the period during which certain types of suits
can be brought against a company or its officers has been extended, and bonuses
issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from trading during
retirement plan "blackout" periods, and loans to company executives are
restricted. In addition, a provision directs that civil penalties levied by the
SEC as a result of any judicial or administrative action under the Act be
deposited in a fund for the benefit of harmed investors. Directors and executive
officers must also report most changes in their ownership of a company's
securities within two business days of the change, and as of the end of June
2004, all ownership reports must be electronically filed.

SOX also increases the oversight and authority of audit committees of
publicly traded companies. Audit committee members must be independent and are
barred from accepting consulting, advisory or other compensatory fees from the
issuer. In addition, all SEC-reporting companies must disclose whether at least
one member of the committee is an audit committee "financial expert" (as such
term is defined by the SEC rules) and if not, why not. Audit committees of
publicly traded companies will have authority to retain their own counsel and
other advisors funded by the company. Audit committees must establish procedures
for the receipt, retention and treatment of complaints regarding accounting and
auditing matters and procedures for confidential, anonymous submission of
employee concerns regarding questionable accounting or auditing matters. It is
the responsibility of the audit committee to hire, oversee and work on
disagreements with the Company's independent auditor.

29

Beginning six months after the SEC determines that the PCAOB is able to
carry out its functions, it will be unlawful for any person that is not a
registered public accounting firm ("RPAF") to audit an SEC-reporting company.
Under SOX, a RPAF is prohibited from performing statutorily mandated audit
services for a company if such company's chief executive officer, chief
financial officer, comptroller, chief accounting officer or any person serving
in equivalent positions has been employed by such firm and participated in the
audit of such company during the one-year period preceding the audit initiation
date. SOX also prohibits any officer or director of a company or any other
person acting under their direction from taking any action to fraudulently
influence, coerce, manipulate or mislead any independent public or certified
accountant engaged in the audit of the Company's financial statements for the
purpose of rendering the financial statement's materially misleading. The SEC
has prescribed rules requiring inclusion of an internal control report and
assessment by management in the annual report to shareholders. SOX requires the
RPAF that issues the audit report to attest to and report on management's
assessment of the Company's internal controls. In addition, SOX requires that
each financial report required to be prepared in accordance with (or reconciled
to) generally accepted accounting principles and filed with the SEC reflect all
material correcting adjustments that are identified by a RPAF in accordance with
generally accepted accounting principles and the rules and regulations of the
SEC.

Although the Company anticipates it will incur additional expense in
complying with the provisions of the Act and the related rules, management does
not expect that such compliance will have a material impact on the Company's
financial condition or results of operations.

Taxation - General

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

Federal Income Taxation

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

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

State Income Taxation

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

For additional information regarding taxation, see Notes 1 and 10 of Notes
to Consolidated Financial Statements in the Annual Report.

30

Item 2. Properties

The following table sets forth the location and certain additional
information regarding the Bank's offices at December 31, 2004.

Book Value at
Year Owned or December 31, Approximate
Opened Leased 2004 Square Footage
------ -------- ------- --------------
(Dollars in thousands)

Main Office:
1311 Carolina Avenue
Washington, NC 1986 Owned $ 913 10,200

Branch Offices:
300 North Market Street
Washington, NC 1959 Owned 115 4,680

1328 John Small Avenue
Washington, NC 2001 Leased 28 1,916

301 E. Arlington Blvd.
Greenville, NC 1993 Owned 342 2,600

604 E. Ehringhaus Street
Elizabeth City, NC 1980 Owned 150 2,500

2430 Heritage Street
Kinston, NC 2001 Leased 74 2,145

1725 Glenburnie Road
New Bern, NC 1990 Owned 472 2,600

202 Craven Street
New Bern, NC 1995 Leased 11 2,500

300 Sunset Avenue
Rocky Mount, NC 1994 Owned 334 4,948

241 Green Street
Fayetteville, NC 1999 Owned 783 10,000

3107 Raeford Road
Fayetteville, NC 1999 Owned 396 2,400

600 N. Chestnut Street
Lumberton, NC 1999 Owned 351 6,100

3000 N. Elm Street
Lumberton, NC 2001 Leased 84 2,128

(Chart continued on next page)

31

Book Value at
Year Owned or December 31, Approximate
Opened Leased 2004 Square Footage
------ -------- ------- --------------
(Dollars in thousands)

2999 Hwy. 17S.
Chocowinity, NC 1999 ** $ 264 2,530

1906 S. Croatan Street
Kill Devil Hills, NC 2002 Leased 94 2,000

4800 Six Forks Road
Six Forks III, Suite #115
Raleigh, NC 2004 Leased 116 4,501

3103 N. Main Street
Hope Mills, NC 2004 Owned 589 2,200

3635 North Halifax Road
Dortches, NC 2000 Leased 40 396

1378 Benvenue Road
Rocky Mount, NC 2000 ** 361 5,376

2901 Sunset Avenue
Rocky Mount, NC 2000 Owned 1,085 5,635

450 North Winstead Avenue
Rocky Mount, NC 2000 Leased 4 2,845

100 East Hope Lodge Street
Tarboro, NC 2000 Leased 16 1,350

Credit Administration:
239 West Main Street
Washington, NC 27889 1994 Owned 401 7,600

Operations Center:
220 Creekside Drive
Washington, NC 2001 Owned 683 10,000

Future Expansion Sites:
Cypress Landing
Chocowinity, NC Owned 126

Taberna
New Bern, NC Owned 176

(Chart continued on next page)

32

Book Value at
Year Owned or December 31, Approximate
Opened Leased 2004 Square Footage
------ -------- ------- --------------
(Dollars in thousands)

2019 S. Glenburnie Road 2004 Leased 77 435
Crossroads Shopping Center
New Bern, NC 28562

907 E. Firetower Road 2005 Owned 307 2,245
Greenville, NC 27858
(building under
construction)

2600 N. Croatan Street 2004 Leased 4 688
Kill Devil Hills, NC 27948

1802 Martin Luther King 2004 Leased 6 950
Jr. Parkway
Suite 108
Durham, NC 27707

40894 NC Highway 12 2005 Leased -- 120
Suite #5
Avon, NC 27915

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

The book value of the Bank's investment in premises and equipment was $8.4
million at December 31, 2004. See Note 5 to Consolidated Financial Statements.

Item 3. Legal Proceedings

From time to time, the Company and/or the Bank is a party to various legal
proceedings incident to their business. At December 31, 2004, there were no
legal proceedings to which the Company or the Bank was a party, or to which any
of their property was subject, which were expected by management to result in a
material loss to the Company or the Bank. There are no pending regulatory
proceedings to which the Company or the Bank is a party or to which either of
their properties is subject which are currently expected to result in a material
loss.

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

Not applicable.

33

PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholders'
Matters

The information contained in the section captioned "Market Information" in
the Company's Annual Report to Stockholders for the Fiscal Year Ended December
31, 2004 (the "Annual Report") filed as Exhibit 13 hereto is incorporated herein
by reference.

Item 6. Selected Financial Data

The information contained in the table captioned "Selected Consolidated
Financial and Other Data" on page 2 in the Annual Report is incorporated herein
by reference.

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

The information contained in the section captioned "Management's
Discussion and Analysis of Financial Condition and Results of Operations" on
pages 3 through 13 in the Annual Report is incorporated herein by reference.

The report of PricewaterhouseCoopers LLP with respect to the consolidated
statements of financial condition, operations, changes in stockholder's equity,
and cash flows of the Company as of December 31, 2004 and for the years ended
December 31, 2003 and 2002 follows.

Report of Independent Registered Public Accounting Firm

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

In our opinion, the consolidated statement of financial condition as of December
31, 2003 and the related consolidated statements of operations, of changes in
stockholders' equity and of cash flows for each of the two years in the period
ended December 31, 2003 (appearing on pages 16 through 19 of the First South
Bancorp, Inc. 2004 Annual Report to Shareholders which has been incorporated by
reference in this Form 10-K present fairly, in all material respects, the
financial position, results of operations and cash flows of First South Bancorp,
Inc. and Subsidiary at December 31, 2003 and for each of the two years in the
period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Harrisburg, Pennsylvania
March 4, 2004

34

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The information contained in the section captioned "Market Risk" on page 5
in the Annual Report is incorporated herein by reference.

Item 8. Financial Statements and Supplementary Data

The Report of Independent Auditors, Consolidated Financial Statements,
Notes to Consolidated Financial Statements and Selected Financial Data contained
on pages 14 through 38 in the Annual Report, which are listed under Item 14
herein, are incorporated herein by reference.

Item 9. Changes in and Disagreements With Independent Registered Public
Accounting Firms on Accounting and Financial Disclosure

The information contained under the section captioned "Relationship with
Independent Public Accountants" in the Company's definitive proxy statement for
the Company's 2005 Annual Meeting of Stockholders (the "Proxy Statement") is
incorporated herein by reference.

Item 9A. Controls and Procedures

As of the end of the period covered by this report, management of the
Company carried out an evaluation, under the supervision and with the
participation of the Company's principal executive officer and principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures. Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by the Company in reports that it files or submits under the
Securities Exchange Act of 1934, 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.

There have been no changes in the Company's internal control over
financial reporting 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.

At this time, pursuant to Release No. 50574 issued by the Securities and
Exchange Commission on November 30, 2004 (the "Release"), the Company has not
filed in this Annual Report on Form 10-K management's annual report on internal
control over financial reporting, nor has the Company filed the related
attestation report of the Company's independent accountants, as contemplated by
Item 308 of Regulation S-K. Pursuant to the Release, the Company anticipates
that it will file an amendment to this Annual Report on Form 10-K no later than
May 2, 2005 to include management's annual report on internal control over
financial reporting and the related attestation report of the Company's
independent accountants. Prior to the filing of this Annual Report on Form 10-K,
neither the Company nor its independent registered public accounting firm has
identified any material weakness in the Company's internal control over
financial reporting.

Item 9B. Other Information

Not applicable.

35

PART III

Item 10. Directors and Executive Officers of the Registrant

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

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

Item 11. Executive Compensation

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

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

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

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

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

(d) Equity Compensation Plans. The following table sets forth certain
information with respect to the Company's equity compensation plans
as of December 31, 2004.

(a) (b) (c)
Number of securities remaining
Number of securities to be available for future issuance
issued upon exercise of Weighted-average exercise under equity compensation
outstanding options, price of outstanding plans (excluding securities
warrants & rights options, warrants and rights reflected in column (a))
----------------- ---------------------------- ------------------------

Equity compensation plans
approved by security holders 773,974 $10.17 700,768

Equity compensation plans not
approved by security holders -- -- --
------- ------ -------
Total 773,974 $10.17 700,768
======= ====== =======

Item 13. Certain Relationships and Related Transactions

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

Item 14. Principal Accountant Fees and Services

Information required by this item is incorporated herein by reference to
the section captioned "Audit and Other Fees Paid to Independent Accountant" in
the Proxy Statement.

36

PART IV

Item 15. Exhibits and Financial Statement Schedules

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

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

Report of Independent Registered Public Accounting Firm

Consolidated Statements of Financial Condition as of December 31, 2004 and
2003

Consolidated Statements of Operations for the Years Ended December 31,
2004, 2003 and 2002

Consolidated Statements of Changes in Stockholders Equity for the Years
Ended December 31, 2004 and 2003 and 2002

Consolidated Statements of Cash Flows for the Years Ended December 31,
2004 and 2003 and 2002

Notes to Consolidated Financial Statements

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

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

No. Description
- --- -----------

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

37

10.6 First South Bank Director's Retirement Plan Agreements as Amended and
Restated December 14, 1995 with Edmund T. Buckman, Jr., Linley H. Gibbs,
Jr., Frederick N. Holscher, Frederick H. Howdy, Charles E. Parker, Jr.
and Thomas A. Vann, the 1996 Amendment thereto and the 2004 Amendment
thereto (Incorporated herein by reference from the Company's Annual
Report on Form 10-K for the Year Ended December 31, 2003 (File No.
0-22219))*
10.7 Home Savings Bank, SSB Director's Retirement Payment Agreements as
Amended and Restated December 14, 1995 with Edmund T. Buckman, Jr.,
Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick H. Howdy, Charles
E. Parker, Jr., and Thomas A. Vann and the 1996 Amendment Thereto
(Incorporated herein by reference from Exhibit 10.9 to the Company's
Registration Statement on Form S-1 (File No. 333-16335))*
10.8 Home Savings Bank, SSB Directors Retirement Plan Agreement with Marshall
Singleton and the 2004 Amendment thereto (Incorporated herein by
reference from the Company's Annual Report on Form 10-K for the Year
Ended December 31, 2003 (File No. 0-22219))*
10.9 First South Bancorp, Inc. 1997 Stock Option Plan, as amended
(Incorporated herein by reference from Exhibit 10.10 to the Company's
Annual Report on Form 10-K for the Year Ended September 30, 1999 (File
No. 0-22219))*
10.10 Supplemental Income Plan Agreement between First South Bank and Robert
E. Branch dated September 21, 2004
10.11 Change-in-Control Protective Agreement between First South Bank, First
South Bancorp, Inc. and Robert E. Branch dated January 27, 2005
10.12 Change-in-Control Protective Agreement between First South Bank, First
South Bancorp, Inc. and William L. Wall dated January 1, 2001
(Incorporated herein by reference from Exhibit 10.12 to the Company's
Annual Report on Form 10-K for the Year Ended September 30, 2001 (File
No. 0-22219))*
10.13 Trust Preferred Securities Guarantee Agreement between First South
Bancorp, Inc., and The Bank of New York dated September 26, 2003
(Incorporated herein by reference from the Company's Annual Report on
Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))
13 Annual Report to Stockholders for the Fiscal Year Ended December 31,
2004
21 Subsidiaries of the Registrant
23.1 Consent of PricewaterhouseCoopers LLP
23.2 Consent of Dixon Hughes PLLC
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32 Certification pursuant to 18 U.S.C. Section 1350
* Compensatory plan or arrangement

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

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

38

SIGNATURES

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

FIRST SOUTH BANCORP, INC.

March 11, 2005
By: /s/ Thomas A. Vann
------------------------------
Thomas A. Vann
President

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

/s/ Thomas A. Vann March 11, 2005
- --------------------------------------------
Thomas A. Vann
President and Director
(Principal Executive Officer)

/s/ William L. Wall March 11, 2005
- --------------------------------------------
William L. Wall
Executive Vice President, Chief Financial
Officer and Secretary
(Principal Financial and Accounting Officer)

/s/ Edmund T. Buckman, Jr. March 11, 2005
- --------------------------------------------
Edmund T. Buckman, Jr.
Director

/s/ Linley H. Gibbs, Jr. March 11, 2005
- --------------------------------------------
Linley H. Gibbs, Jr.
Director

/s/ Frederick N. Holscher March 11, 2005
- --------------------------------------------
Frederick N. Holscher
Director

/s/ Frederick H. Howdy March 11, 2005
- --------------------------------------------
Frederick H. Howdy
Director

/s/ Charles E. Parker, Jr. March 11, 2005
- ---------------------------------------------
Charles E. Parker, Jr.
Director

/s/ Marshall T. Singleton March 11, 2005
- --------------------------------------------
Marshall T. Singleton
Director

/s/ H. D. Reaves, Jr. March 11, 2005
- --------------------------------------------
H. D. Reaves, Jr.
Director

39