- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2012.

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

For the transition period from ____ to ____.

Commission File Number : 0-22219

FIRST SOUTH BANCORP, INC.

(Exact name of registrant as specified in its charter)

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

1311 Carolina Avenue, Washington, North Carolina 27889

(Address of principal executive offices)

(Zip Code)

(252) 946-4178

(Registrant's telephone number, including area code)

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

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

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

Large Accelerated Filer ¨		Accelerated Filer ¨
Non-Accelerated Filer ¨		Smaller Reporting Company x
(Do not check if a Smaller Reporting Company)

Indicate by check mark whether registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

Yes ¨ No x

Number of shares of common stock outstanding as of November 8, 2012: 9,751,271.

CONTENTS

		PAGE

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Statements of Financial Condition as of September 30, 2012 (unaudited) and December 31, 2011	1

	Consolidated Statements of Operations and Comprehensive Income for the Three and Nine Months Ended September 30, 2012 and 2011 (unaudited)	2

	Consolidated Statements of Changes in Stockholders' Equity for the Nine Months Ended September 30, 2012 and 2011 (unaudited)	3

	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011 (unaudited)	4

	Notes to Consolidated Financial Statements (unaudited)	5

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	22

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31

Item 4.	Controls and Procedures	31

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	32

Item 1A.	Risk Factors	32

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	32

Item 3.	Defaults Upon Senior Securities	32

Item 4.	Mine Safety Disclosures	32

Item 5.	Other Information	32

Item 6.	Exhibits	32

Signatures		33

Exhibits

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Financial Condition

	September 30,			December 31,
	2012			2011
	(unaudited)
Assets

Cash and due from banks	$	11,480,221		$	14,298,146
Interest-earning deposits with banks		6,030,941			18,476,173
Investment securities available for sale, at fair value		172,714,688			138,515,210
Loans and leases receivable:
Held for sale		699,928			6,435,983
Held for investment		490,784,538			533,960,226
Allowance for loan and lease losses		(15,007,009	)		(15,194,014	)
Loans and leases receivable, net		476,477,457			525,202,195
Premises and equipment, net		12,428,109			11,679,430
Other real estate owned		18,003,025			17,004,874
Federal Home Loan Bank stock, at cost		1,634,200			1,886,900
Accrued interest receivable		2,409,473			2,210,314
Goodwill		4,218,576			4,218,576
Mortgage servicing rights		1,339,719			1,237,161
Identifiable intangible assets		47,160			70,740
Income tax receivable		2,472,843			2,194,677
Prepaid expenses and other assets		7,905,197			9,946,459

Total assets	$	717,161,609		$	746,940,855

Liabilities and Stockholders' Equity

Deposits:
Demand	$	268,243,332		$	243,719,526
Savings		30,611,359			28,988,522
Large denomination certificates of deposit		157,823,418			195,429,182
Other time		152,822,862			174,479,477
Total deposits		609,500,971			642,616,707
Borrowed money		1,973,638			2,096,189
Junior subordinated debentures		10,310,000			10,310,000
Other liabilities		7,255,336			7,804,687
Total liabilities		629,039,945			662,827,583

Common stock, $.01 par value, 25,000,000 shares authorized; 11,254,222 shares issued; 9,751,271 shares outstanding		97,513			97,513
Additional paid-in capital		35,757,978			35,815,098
Retained earnings, substantially restricted		78,418,693			76,510,081
Treasury stock, at cost		(31,967,269	)		(31,967,269	)
Accumulated other comprehensive income, net		5,814,749			3,657,849
Total stockholders' equity		88,121,664			84,113,272

Total liabilities and stockholders' equity	$	717,161,609		$	746,940,855

*Derived from audited consolidated financial statements

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Operations and Comprehensive Income

(unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011

Interest income:
Interest and fees on loans	$	6,903,027		$	8,582,320		$	22,016,871		$	26,312,194
Interest and dividends on investments and deposits		1,442,019			1,278,399			4,059,730			3,628,175
Total interest income		8,345,046			9,860,719			26,076,601			29,940,369

Interest expense:
Interest on deposits		1,002,028			1,767,524			3,572,852			5,669,228
Interest on borrowings		2,456			1,513			4,495			30,480
Interest on junior subordinated notes		91,671			83,019			274,981			248,250
Total interest expense		1,096,155			1,852,056			3,852,328			5,947,958
Net interest income		7,248,891			8,008,663			22,224,273			23,992,411
Provision for credit losses		1,961,965			2,643,282			4,576,965			8,173,293
Net interest income after provision for credit losses		5,286,926			5,365,381			17,647,308			15,819,118

Non-interest income:
Fees and service charges		1,445,990			1,485,776			4,380,751			4,554,400
Loan servicing fees		191,774			195,338			607,352			590,409
Loss on sale of other real estate, net		(56,176	)		(15,710	)		(132,197	)		(44,418	)
Gain on sale of mortgage loans		858,483			165,418			1,427,357			396,946
Gain on sale of investment securities		27,979			204,248			1,546,883			256,394
Other income		186,492			257,074			719,002			1,018,074
Total non-interest income		2,654,542			2,292,144			8,549,148			6,771,805

Non-interest expense:
Compensation and fringe benefits		3,634,348			3,658,126			12,179,449			11,389,382
Federal deposit insurance premiums		234,061			387,679			745,547			972,462
Premises and equipment		520,663			416,189			1,487,943			1,272,981
Advertising		23,217			45,670			156,782			131,055
Payroll and other taxes		332,598			338,058			1,095,872			1,092,206
Data processing		344,322			699,089			1,558,281			1,922,489
Amortization of intangible assets		115,388			149,257			340,887			442,038
Other real estate owned expense		315,660			579,001			2,901,057			1,063,602
Other		903,179			725,597			2,796,671			2,486,766
Total non-interest expense		6,423,436			6,998,666			23,262,489			20,772,981

Income before income tax expense		1,518,032			658,859			2,933,967			1,817,942
Income tax expense		552,067			255,588			1,025,355			705,799

NET INCOME	$	965,965		$	403,271		$	1,908,612		$	1,112,143

Other comprehensive income, net of taxes		1,042,543			810,839			2,156,900			1,434,070
Comprehensive income	$	2,008,508		$	1,214,110		$	4,065,512		$	2,546,213

Per share data:
Basic earnings per share	$	0.10		$	0.04		$	0.20		$	0.11
Diluted earnings per share	$	0.10		$	0.04		$	0.20		$	0.11
Average basic shares outstanding		9,751,271			9,751,271			9,751,271			9,751,271
Average diluted shares outstanding		9,754,794			9,751,271			9,752,434			9,751,271

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders' Equity

Nine Months Ended September 30, 2012 and 2011

(unaudited)

											Accumulated
						Retained					Other
			Additional			Earnings,					Comprehensive
	Common		Paid-in			Substantially		Treasury			Income,
	Stock		Capital			Restricted		Stock			Net		Total

Balance at December 31, 2011	$	97,513	$	35,815,098		$	76,510,081	$	(31,967,269	)	$	3,657,849	$	84,113,272

Net income							1,908,612							1,908,612

Other comprehensive income, net of taxes												2,156,900		2,156,900

Stock based compensation				(57,120	)									(57,120	)

Balance at September 30, 2012	$	97,513	$	35,757,978		$	78,418,693	$	(31,967,269	)	$	5,814,749	$	88,121,664

										Accumulated
					Retained					Other
			Additional		Earnings,					Comprehensive
	Common		Paid-in		Substantially		Treasury			Income,
	Stock		Capital		Restricted		Stock			Net		Total

Balance at December 31, 2010	$	97,513	$	35,795,586	$	74,956,772	$	(31,967,269	)	$	630,602	$	79,513,204

Net income						1,112,143							1,112,143

Other comprehensive income, net of taxes											1,434,070		1,434,070

Stock based compensation				1,353									1,353

Balance at September 30, 2011	$	97,513	$	35,796,939	$	76,068,915	$	(31,967,269	)	$	2,064,672	$	82,060,770

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

First South Bancorp, Inc. and Subsidiary

Consolidated Statements of Cash Flows

(unaudited)

	Nine Months Ended
	September 30,
	2012			2011

Cash flows from operating activities:
Net income	$	1,908,612		$	1,112,143
Adjustments to reconcile net income to net cash used in operating activities:
Provision for credit losses		4,576,965			8,173,293
Depreciation		782,686			552,197
Amortization of intangibles		340,887			442,038
Accretion of discounts and premiums on securities, net		160,118			246,067
Gain on disposal of premises and equipment		(2,168	)		(328,215	)
Loss on sale of other real estate owned		132,197			44,418
Gain on sale of loans held for sale		(1,427,357	)		(396,946	)
Gain on sale of mortgage-backed securities available for sale		(1,546,883	)		(256,394	)
Stock based compensation expense (income)		(57,120	)		1,353
Originations of loans held for sale, net		(58,526,668	)		(37,600,903	)
Proceeds from sale of loans held for sale		24,655,516			15,619,565
Other operating activities		1,749,234			4,776,785
Net cash used in operating activities		(27,253,981	)		(7,614,599	)
Cash flows from investing activities:
Proceeds from sale of investment securities available for sale		32,973,938			5,891,740
Proceeds from principal repayments of mortgage-backed securities available for sale		16,959,684			5,251,531
Proceeds from principal repayments of mortgage-backed securities held for investment		-			2,614,037
Originations of loans held for investment, net of principal repayments		30,478,907			34,916,684
Proceeds from disposal of other real estate owned		4,696,983			4,693,635
Proceeds from disposal of premises and equipment		96,041			383,430
Purchase of investment securities		(38,603,904	)		(23,087,178	)
Sale of FHLB stock		252,700			1,170,600
Purchase of premises and equipment		(1,625,238	)		(1,902,503	)
Net cash provided by investing activities		45,229,111			29,931,976
Cash flows from financing activities:
Net decrease in deposit accounts		(33,115,736	)		(24,324,742	)
Net decrease in FHLB borrowings		-			(10,000,000	)
Net change in repurchase agreements		(122,551	)		482,704
Net cash used in financing activities		(33,238,287	)		(33,842,038	)

Decrease in cash and cash equivalents		(15,263,157	)		(11,524,661	)
Cash and cash equivalents, beginning of period		32,774,319			44,433,613
Cash and cash equivalents, end of period	$	17,511,162		$	32,908,952

Supplemental disclosures:
Other real estate acquired in settlement of loans	$	7,932,811		$	8,537,752
Exchange of loans for mortgage-backed securities		41,034,564			8,591,293
Cash paid for interest		3,753,459			5,697,324
Cash paid for income taxes		140,000			-

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

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1. Basis of Presentation. The accompanying unaudited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments necessary for fair presentation of the financial position and results of operations for the periods presented are included, none of which are other than normal recurring accruals. The financial statements of First South Bancorp, Inc. (the “Company”) and First South Bank (the “Bank”) are presented on a consolidated basis. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2012.

Note 2. Earnings Per Share. Basic and diluted earnings per share for the three and nine months ended September 30, 2012 are based on weighted average shares of common stock outstanding, excluding treasury shares. Diluted earnings per share include the potentially dilutive effects of the Company’s stock option plans. For the three and nine months ended September 30, 2012 there were 3,523 and 1,163 stock options, respectively, that were dilutive because their exercise prices were less than the average market price of the Company’s common stock. For the three and nine months ended September 30, 2011 there were no stock options that were dilutive because their exercise prices exceeded the average market price of the Company’s common stock.

Note 3. Comprehensive Income. Comprehensive income includes net income and changes in other comprehensive income. The Company's components of other comprehensive income primarily includes net changes in unrealized gains and losses on available for sale securities, and the reclassification of net gains and losses on available for sale securities recognized in income during the respective reporting periods. Information concerning other comprehensive income for the three and nine months ended September 30, 2012 and 2011 is presented below:

	Three Months Ended 9/30/12			Three Months Ended 9/30/11			Nine Months Ended 9/30/12			Nine Months Ended 9/30/11
Net income	$	965,965		$	403,271		$	1,908,612		$	1,112,143
Increase in unrealized holding gains		1,721,129			1,539,536			4,654,750			3,206,721
Tax effect		(661,374	)		(603,187	)		(1,547,332	)		(1,248,688	)
Reclassification of gains recognized in net income		(27,979	)		(204,248	)		(1,546,883	)		(256,394	)
Tax effect		10,767			78,738			596,365			98,842
Reclassification of unrealized losses transferred to held for investment		-			-			-			(366,411	)
Other comprehensive income		1,042,543			810,839			2,156,900			1,434,070
Comprehensive income	$	2,008,508		$	1,214,110		$	4,065,512		$	2,546,213

Note 4. Investment Securities. The following is a summary of the securities portfolio by major category. The amortized cost and fair value of each category, with gross unrealized gains and losses at September 30, 2012 and December 31, 2011:

	September 30, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities available for sale:	Cost		Gains		Losses		Value
	(In thousands)
Mortgage-backed securities, maturing in:
One to five years	$	225	$	3	$	-	$	228
Five to ten years		1,785		104		-		1,889
After ten years		137,304		8,835		12		146,127
Total	$	139,314	$	8,942	$	12	$	148,244

Municipal securities, maturing in:
One to five years	$	-	$	-	$	-	$	-
Five to ten years		1,607		-		17		1,590
After ten years		22,468		413		-		22,881
Total	$	24,075	$	413	$	17	$	24,471

Total securities portfolio	$	163,389	$	9,355	$	29	$	172,715

	December 31, 2011
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
Securities available for sale:	Cost		Gains		Losses		Value
	(In thousands)
Mortgage-backed securities, maturing in:
One to five years	$	481	$	29	$	-	$	510
Five to ten years		835		62		-		897
After ten years		130,981		6,127		-		137,108
Total	$	132,297	$	6,218	$	-	$	138,515

At September 30, 2012 and December 31, 2011, mortgage-backed securities with fair value of $4.9 million and $5.1 million, respectively, were pledged as collateral for public deposits and repurchase agreements.

The following table summarizes investment securities gross unrealized losses, fair value and length of time the securities have been in a continuous unrealized loss position at September 30, 2012. The Bank had no investment securities with an unrealized loss position at September 30, 2011.

	September 30, 2012
	Less Than 12 Months				12 Months or More				Total
	Fair value		Unrealized losses		Fair Value		Unrealized losses		Fair value		Unrealized losses
	(In thousands)
Mortgage-backed securities	$	2,139		12		-		-		2,139		12
Municipal securities		1,590		17		-		-		1,590		17
	$	3,729	$	29	$	-	$	-	$	3,729	$	29

Note 5. Loans Receivable. Following is a summary of loans receivable at September 30, 2012 and December 31, 2011:

	September 30, 2012					December 31, 2011
	Amount		Percent of total			Amount		Percent of total
	(Dollars in thousands)
Mortgage loans:
Residential mortgage loans	$	75,158		15.3	%	$	68,240		12.6	%

Total mortgage loans		75,158		15.3	%		68,240		12.6	%

Commercial loans and leases:
Commercial real estate		305,611		62.0	%		346,088		63.9	%
Commercial construction		20,649		4.2	%		25,441		4.7	%
Commercial non-real estate		12,449		2.5	%		14,851		2.8	%
Commercial unsecured		3,129		0.6	%		2,832		0.5	%
Lease receivables		6,186		1.3	%		7,578		1.4	%

Total commercial loans and leases		348,024		70.6	%		396,790		73.3	%

Consumer loans:
Consumer real estate		37,254		7.6	%		41,046		7.6	%
Home equity lines of credit		27,528		5.6	%		30,479		5.6	%
Consumer non-real estate		2,158		0.4	%		2,500		0.5	%
Consumer unsecured		2,368		0.5	%		2,403		0.4	%

Total consumer loans		69,308		14.1	%		76,428		14.1	%

Gross loans		492,490		100.0	%		541,458		100.0	%

Less deferred loan origination fees, net		1,006					1,062
Less allowance for loan and lease losses		15,007					15,194

Total loans, net	$	476,477				$	525,202

The Bank has pledged certain loans secured by one-to-four family residential properties as collateral for potential borrowings from the Federal Home Loan Bank of Atlanta in the amount of $97.4 million and $101.2 million at September 30, 2012 and December 31, 2011, respectively.

The table below details non-accrual loans, including troubled debt restructured (“TDR”) loans accounted for on a non-accrual basis, segregated by class of loans, at September 30, 2012 and December 31, 2011.

	September 30, 2012			December 31, 2011
	(Dollars in thousands)
Loans accounted for on a non-accrual basis:
Residential mortgage	$	1,331		$	701
Commercial real estate		11,081			18,059
Commercial construction		367			633
Commercial non-real estate		413			17
Commercial unsecured		77			44
Consumer real estate		756			1,866
Home equity lines of credit		276			287
Consumer non-real estate		-			-
Consumer unsecured		2			1
Total loans accounted for on a non-accrual basis		14,303			21,608

TDR loans accounted for on a non-accrual basis:
Past Due TDRs:
Residential mortgage		-			414
Commercial real estate		6,299			6,888
Commercial construction		-			157
Commercial non-real estate		908			1,509
Commercial unsecured		22			-
Consumer real estate		420			202
Total Past Due TDRs		7,649			9,170
Current TDRs:
Commercial real estate		11,336			9,406
Commercial construction		1,448			2,704
Commercial non-real estate		3			19
Commercial unsecured		12			16
Consumer real estate		50			102
Total Current TDRs		12,849			12,247
Total TDR loans accounted for on a non-accrual basis		20,498			21,417
Total non-accrual and TDR loans	$	34,801		$	43,025
Percentage of total loans, net		7.3	%		8.2	%
Other real estate owned	$	18,003		$	17,005
Total non-performing assets	$	52,804		$	60,030

Cumulative interest income not recorded on loans accounted for on a non-accrual basis was $1.4 million and $1.5 million at September 30, 2012 and December 30, 2011, respectively.

The following tables present an age analysis of past due loans, segregated by class of loans as of September 30, 2012 and December 31, 2011, respectively:

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Over 90 Days and Accruing
September 30, 2012	(In thousands)
Residential mortgage	$	-	$	976	$	1,728	$	2,704	$	72,454	$	75,158	$	799
Commercial real estate		9,610		3,585		16,779		29,974		275,637		305,611		980
Commercial construction		-		52		367		419		20,230		20,649		-
Commercial non-real estate		416		45		920		1,381		11,068		12,449		-
Commercial unsecured		81		8		77		166		2,963		3,129		-
Lease receivables		-		191		18		209		5,977		6,186		18
Consumer real estate		2,179		41		300		2,520		34,734		37,254		57
Home equity lines of credit		67		80		127		274		27,254		27,528		-
Consumer non-real estate		19		-		-		19		2,139		2,158		-
Consumer unsecured		53		-		-		53		2,315		2,368		-
Total	$	12,425	$	4,978	$	20,316	$	37,719	$	454,771	$	492,490	$	1,854

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Over 90 Days and Accruing
December 31, 2011	(In thousands)
Residential mortgage	$	2,998	$	2,040	$	1,626	$	6,664	$	61,576	$	68,240	$	511
Commercial real estate		6,626		5,240		15,372		27,238		318,850		346,088		520
Commercial construction		-		-		790		790		24,651		25,441		-
Commercial non-real estate		-		534		1,514		2,048		12,803		14,851		-
Commercial unsecured		4		-		-		4		2,828		2,832		-
Lease receivables		169		-		5		174		7,404		7,578		-
Consumer real estate		1,322		494		379		2,195		38,851		41,046		-
Home equity lines of credit		204		198		181		583		29,896		30,479		-
Consumer non-real estate		2		-		-		2		2,498		2,500		-
Consumer unsecured		4		1		-		5		2,398		2,403		-
Total	$	11,329	$	8,507	$	19,867	$	39,703	$	501,755	$	541,458	$	1,031

The following tables present information on loans that were considered impaired as of September 30, 2012 and December 31, 2011. Impaired loans include loans modified in a TDR, whether on accrual or non-accrual status. At September 30, 2012, impaired loans included $23.9 million of impaired TDRs, compared to $36.8 million at December 31, 2011.

September 30, 2012	Recorded Investment		Contractual Unpaid Principal Balance		Related Allowance		YTD Average Recorded Investment		Interest Income Recognized on Impaired Loans
	(In thousands)
With no related allowance recorded:
Commercial real estate	$	68,885	$	74,548	$	-	$	64,840	$	2,501
Commercial construction		2,538		2,538		-		3,260		41
Commercial non-real estate		1,307		2,388		-		1,586		48
Commercial unsecured		173		212		-		211		19
Consumer real estate		2,570		2,693		-		1,960		83
Home equity lines of credit		211		211		-		219		6
Consumer non-real estate		26		26		-		27		1
Consumer unsecured		48		48		-		43		1
Subtotal:		75,758		82,664		-		72,146		2,700

With an allowance recorded:
Commercial real estate		10,990		11,066		2,236		8,357		392
Commercial non-real estate		12		12		12		6		-
Commercial unsecured		33		33		2		32		2
Consumer real estate		1,614		1,614		517		1,166		58
Consumer unsecured		47		47		1		59		1
Subtotal:		12,696		12,772		2,768		9,620		453

Totals:
Commercial		83,938		90,797		2,250		78,292		3,003
Consumer		4,516		4,639		518		3,474		150
Grand Total:	$	88,454	$	95,436	$	2,768	$	81,766	$	3,153

December 31, 2011	Recorded Investment		Contractual Unpaid Principal Balance		Related Allowance		YTD Average Recorded Investment		Interest Income Recognized on Impaired Loans
	(In thousands)
With no related allowance recorded:
Commercial real estate	$	62,505	$	74,021	$	-	$	70,143	$	3,177
Commercial construction		3,868		4,159		-		4,008		121
Commercial non-real estate		2,230		2,900		-		2,395		85
Commercial unsecured		211		247		-		235		11
Consumer real estate		1,543		2,253		-		1,716		93
Home equity lines of credit		270		270		-		271		14
Consumer non-real estate		28		35		-		35		2
Consumer unsecured		1		179		-		2		5
Subtotal:		70,656		84,064		-		78,805		3,508
With an allowance recorded:
Commercial real estate		7,152		7,152		1,158		7,210		328
Commercial unsecured		50		50		1		50		2
Consumer real estate		937		937		451		947		47
Consumer unsecured		95		95		1		95		2
Subtotal:		8,234		8,234		1,611		8,302		379

Totals:
Commercial		76,016		88,529		1,159		84,041		3,724
Consumer		2,874		3,769		452		3,066		163
Grand Total:	$	78,890	$	92,298	$	1,611	$	87,107	$	3,887

Credit Quality Indicators . The Bank assigns a risk grade to each loan in the portfolio as part of the on-going monitoring of the credit quality of the loan portfolio.

Commercial and consumer loans are graded on a scale of 1 to 9 as follows:

•

Risk Grade 1 (Excellent) - Loans in this category are considered to be of the highest quality. The borrower(s) has significant financial strength, stability, and liquidity. Proven cash flow is significantly more than required to service current and proposed debt with consistently strong earnings. Collateral position is very strong and a secondary source of repayment is self-evident. Guarantors may not be necessary to support the debt.

•

Risk Grade 2 (Above Average) - Loans are supported by above average financial strength and stability. Cash flow is more than sufficient to meet current demands. Earnings are strong and reliable, but may differ from year to year. Collateral is highly liquid and sufficient to repay the debt in full. Guarantors may qualify for the loan on a direct basis.

•

Risk Grade 3 (Average) - Credits in this group are supported by upper tier industry-average financial strength and stability. Liquidity levels fluctuate and need for short-term credit is demonstrated. Cash flow is steady and adequate to meet demands but can fluctuate. Earnings should be consistent but operating losses have not occurred recently. Collateral is generally pledged at an acceptable loan to value, but the credit can support some level of unsecured exposure. Guarantors with demonstrable financial strength are typically required on loans to business entities, but may not be on loans to individual borrowers.

•

Risk Grade 4 (Acceptable) - Credits in this group are supported by lower end industry-average financial strength and stability. Liquidity levels fluctuate but are acceptable and need for short term credit is demonstrated. Cash flow is adequate to meet demands but can fluctuate. Earnings may be inconsistent but operating losses have not occurred recently. Collateral is generally pledged at an acceptable loan to value. Guarantors with demonstrable financial strength are required on loans to business entities, but may not be on loans to individual borrowers.

•

Risk Grade 5 (Watch) - An asset in this category is one that has been identified by the lender, or credit administration as a loan that has shown some degree of deterioration from its original status. These loans are typically protected by collateral but have potential weaknesses that deserve management’s close attention, but are not yet at a point to become a classified asset. There may be unsecured loans that are included in this category. These are loans that management feels need to be watched more closely than those rated as acceptable and if left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset to warrant including them as classified assets.

•

Risk Grade 6 (Special Mention) - An asset in this category is currently protected by collateral but has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.

•

Risk Grade 7 (Substandard) - A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the debtor(s) or of the collateral pledged, if any. These credits have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility the Bank will sustain some loss if the deficiencies are not corrected.

•

Risk Grade 8 (Doubtful) - A loan graded in this category has all the weaknesses inherent in one graded Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values highly questionable and improbable.

•

Risk Grade 9 (Loss) - A loan graded as Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted. This grade does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

Mortgage loans are graded on a scale of 1 to 9 as follows:

•

Risk Grades 1 - 4 (Pass) - Loans in this category generally show little to no signs of weakness or have adequate mitigating factors that minimize the risk of loss. Some of the characteristics of these loans include, but are not limited to, adequate financial strength and stability, acceptable credit history, adequate cash flow, collateral with acceptable loan to value, additional repayment sources, and reliable earnings.

•

Risk Grade 5 (Watch) – Watch loans have shown credit quality changes from the original status. These loans are typically protected by collateral but have potential weaknesses that deserve management’s close attention, but are not yet at a point to become a classified asset. These are loans that management feels need to be watched more closely than those rated as Pass and if left uncorrected may result in the deterioration of the repayment prospects for the asset to warrant including them as classified assets.

•

Risk Grade 6 (Special Mention) – Special Mention loans are currently protected by collateral but have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.

•

Risk Grade 7 (Substandard) - Substandard loans are inadequately protected by the sound net worth and paying capacity of the borrower(s). Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

•

Risk Grade 8 (Doubtful) - Loans classified Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions, and values, highly questionable and improbable.

•

Risk Grade 9 (Loss) - Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

The following tables present information on risk ratings of the commercial, consumer, mortgage and lease receivable portfolios, segregated by loan class as of September 30, 2012 and December 31, 2011, respectively:

September 30, 2012
Commercial Credit Exposure by Internally Assigned Grade	Commercial Real Estate		Commercial Construction		Commercial Non-Real Estate		Commercial Unsecured
			(In thousands)
1-Excellent	$	-	$	-	$	-	$	-
2-Above Average		1,273		-		562		33
3-Average		23,939		2,235		1,924		311
4-Acceptable		146,279		12,988		6,852		1,529
5-Watch		55,870		2,836		1,732		799
6-Special Mention		23,780		-		30		258
7-Substandard		54,470		2,590		1,349		199
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	305,611	$	20,649	$	12,449	$	3,129

Consumer Credit Exposure by Internally Assigned Grade	Consumer Real Estate		Home Equity Line of Credit		Consumer Non-Real Estate		Consumer Unsecured
	(In thousands)
Pass	$	27,526	$	26,948	$	2,118	$	1,923
5-Watch		4,100		180		13		313
6-Special Mention		3,093		86		1		26
7-Substandard		2,535		314		26		106
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	37,254	$	27,528	$	2,158	$	2,368

Mortgage and Lease Receivable Credit Exposure by Internally Assigned Grade	Mortgage		Lease Receivable
	(In thousands)
Pass	$	73,028	$	6,169
5-Watch		799		-
6-Special Mention		-		17
7-Substandard		1,331		-
8-Doubtful		-		-
9-Loss		-		-
Total	$	75,158	$	6,186

December 31, 2011
Commercial Credit Exposure by Internally Assigned Grade	Commercial Real Estate		Commercial Construction		Commercial Non-Real Estate		Commercial Unsecured
			(In thousands)
1-Excellent	$	-	$	-	$	-	$	-
2-Above Average		1,481		-		581		45
3-Average		25,660		2,506		1,581		451
4-Acceptable		166,476		11,727		9,109		1,638
5-Watch		62,543		4,417		1,221		324
6-Special Mention		32,009		1,928		130		216
7-Substandard		57,919		4,863		2,229		158
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	346,088	$	25,441	$	14,851	$	2,832

Consumer Credit Exposure by Internally Assigned Grade	Consumer Real Estate		Home Equity Line of Credit		Consumer Non-Real Estate		Consumer Unsecured
	(In thousands)
Pass	$	35,931	$	29,902	$	2,472	$	2,285
6-Special Mention		2,814		115		-		22
7-Substandard		2,301		462		28		96
8-Doubtful		-		-		-		-
9-Loss		-		-		-		-
Total	$	41,046	$	30,479	$	2,500	$	2,403

Mortgage and Lease Receivable Credit Exposure by Internally Assigned Grade	Mortgage		Lease Receivable
	(In thousands)
Pass	$	67,034	$	7,500
6-Special Mention		91		-
7-Substandard		1,115		78
8-Doubtful		-		-
9-Loss		-		-
Total	$	68,240	$	7,578

Note 6. Allowance for Credit Losses. Following is a summary of activity in the allowance for credit losses for the periods indicated:

	September 30, 2012			September 30, 2011
	(In thousands)
Allowance for loan and lease losses at beginning of period	$	15,194		$	18,830
Allowance for unfunded commitments at beginning of period		254			237
Total allowance for credit losses at beginning of period		15,448			19,067

Provision for loan and lease losses		4,577			8,173
Provision for unfunded commitments		(10	)		19

Loans charged-off:
Residential mortgage		(386	)		(159	)
Commercial real estate		(4,397	)		(7,028	)
Commercial construction		(52	)		(499	)
Commercial non-real estate		(646	)		(179	)
Commercial unsecured		(60	)		(91	)
Lease receivables		(19	)		(207	)
Consumer real estate		(359	)		(849	)
Home equity lines of credit		(321	)		(116	)
Consumer non-real estate		(23	)		(18	)
Consumer unsecured		(15	)		(184	)
Total charge-offs		(6,278	)		(9,330	)
Recoveries of loans previously charged-off:
Residential mortgage		6			-
Commercial real estate		1,231			367
Commercial construction		102			111
Commercial non-real estate		38			14
Commercial unsecured		19			31
Consumer real estate		83			39
Home equity lines of credit		13			64
Consumer non-real estate		15			2
Consumer unsecured		7			6
Total recoveries		1,514			634

Net charge-offs		(4,764	)		(8,696	)

Allowance for loan and lease losses at end of period		15,007			18,307
Allowance for unfunded commitments at end of period		244			256
Total allowance for credit losses at end of period	$	15,251		$	18,563

The following table presents a roll forward of the Bank’s allowance for loan and lease losses by loan category for the periods ended September 30, 2012 and December 31, 2011, respectively:

	September 30, 2012
	Beginning		Charge-								Ending		Total
	Balance		Offs			Recoveries		Provisions			Balance		Loans
	(In thousands)
Allowance for collectively evaluated for impairment
Residential mortgage	$	2,004	$	(386	)	$	6	$	271		$	1,895	$	75,158
Commercial real estate		8,117		(67	)		19		(2,169	)		5,900		225,736
Commercial construction		633		-			-		(161	)		472		18,111
Commercial non-real estate		371		(25	)		11		(67	)		290		11,130
Commercial unsecured		75		(15	)		3		18			81		2,923
Lease receivables		223		(19	)		-		46			250		6,186
Consumer real estate		1,132		(1	)		13		565			1,709		33,070
Home equity lines of credit		887		-			12		515			1,414		27,317
Consumer non-real estate		73		-			11		27			111		2,132
Consumer unsecured		68		(15	)		6		58			117		2,273
Total		13,583		(528	)		81		(897	)		12,239		404,036

Allowance for individually evaluated for impairment
Commercial real estate		1,160		(4,330	)		1,212		4,194			2,236		79,875
Commercial construction		-		(52	)		102		(50	)		-		2,538
Commercial non-real estate		-		(621	)		27		606			12		1,319
Commercial unsecured		-		(45	)		16		31			2		206
Consumer real estate		450		(358	)		70		355			517		4,184
Home equity lines of credit		-		(321	)		1		320			-		211
Consumer non-real estate		-		(23	)		4		19			-		26
Consumer unsecured		1		-			1		(1	)		1		95
Total		1,611		(5,750	)		1,433		5,474			2,768		88,454
Grand Total	$	15,194	$	(6,278	)	$	1,514	$	4,577		$	15,007	$	492,490

	December 31, 2011
	Beginning		Charge-								Ending		Total
	Balance		Offs			Recoveries		Provisions			Balance		Loans
	(In thousands)
Allowance for collectively evaluated for impairment
Residential mortgage	$	358	$	(445	)	$	1	$	2,090		$	2,004	$	68,240
Commercial real estate		10,718		(256	)		66		(2,411	)		8,117		276,431
Commercial construction		1,192		(34	)		3		(528	)		633		21,573
Commercial non-real estate		316		-			6		49			371		12,621
Commercial unsecured		74		(37	)		32		6			75		2,571
Lease receivables		148		(207	)		-		282			223		7,578
Consumer real estate		1,653		(130	)		23		(414	)		1,132		38,566
Home equity lines of credit		1,102		(86	)		64		(193	)		887		30,209
Consumer non-real estate		29		(6	)		4		46			73		2,472
Consumer unsecured		52		(70	)		8		78			68		2,307
Total		15,642		(1,271	)		207		(995	)		13,583		462,568

Allowance for individually evaluated for impairment
Commercial real estate		2,846		(11,773	)		304		9,783			1,160		69,657
Commercial construction		95		(487	)		109		283			-		3,868
Commercial non-real estate		19		(179	)		9		151			-		2,230
Commercial unsecured		54		(82	)		1		27			-		261
Consumer real estate		91		(782	)		19		1,122			450		2,480
Home equity lines of credit		83		(398	)		3		312			-		270
Consumer non-real estate		-		(12	)		4		8			-		28
Consumer unsecured		-		(122	)		1		122			1		96
Total		3,188		(13,835	)		450		11,808			1,611		78,890
Grand Total	$	18,830	$	(15,106	)	$	657	$	10,813		$	15,194	$	541,458

Historical Loss and Qualitative Analysis. The assessment of the adequacy of the allowance for credit losses includes an analysis of actual historical loss percentages of both classified and pass loans and qualitative factors allocated among specific categories of loans. In developing this analysis, the Bank relies on actual loss history for the most recent eight quarters and exercises management’s best judgment in assessing credit risk. There were no changes in the Bank’s accounting policy and methodology used to estimate the allowance for credit losses during this reporting period. The following table sets forth information with respect to the Bank’s allocation of historical loss percentages used in determining the allowance for credit losses for each of the loan categories and risk grades at September 30, 2012.

	Historical Loss Percentage by Assigned Risk Grade
Category – Commercial Loans	9			8			7			6			5			4			3			2			1
Commercial Real Estate		100.00	%		97.83	%		16.35	%		0.20	%		0.03	%		0.02	%		0.02	%		0.02	%		0.00	%
Commercial Non-Real Estate Secured		100.00	%		97.85	%		26.33	%		4.28	%		0.35	%		0.00	%		0.00	%		0.00	%		0.00	%
Commercial Non-Real Estate Unsecured		100.00	%		97.85	%		19.28	%		0.00	%		0.80	%		0.00	%		0.00	%		0.00	%		0.00	%

Category – Other Loans	9			8			7			6			Pass
Consumer Real Estate		100.00	%		98.06	%		47.62	%		11.00	%		0.00	%
Consumer Non-Real Estate Secured		100.00	%		98.06	%		64.57	%		98.06	%		0.00	%
Consumer Non-Real Estate Unsecured		100.00	%		98.05	%		98.05	%		9.69	%		0.97	%
Residential Real Estate		100.00	%		98.15	%		36.86	%		0.36	%		0.00	%
Lease Receivables		100.00	%		97.95	%		75.19	%		97.95	%		1.23	%

Unfunded Commitments
Commercial Real Estate Lines of Credit	0.20	%
Commercial Non-Real Estate Lines of Credit	0.20	%
Commercial Standby Letters of Credit	0.20	%
Home Equity Lines of Credit	0.20	%
Consumer Real Estate Lines of Credit	0.20	%
Consumer Non-Real Estate Lines of Credit	0.20	%
Work-in-Process	0.20	%

Note 7. Troubled Debt Restructurings. The following table details performing TDR loans at September 30, 2012 and December 31, 2011 segregated by class of financing receivables:

	September 30, 2012			December 31, 2011
	(Dollars in thousands)
Performing TDR loans accounted for on an accrual basis:
Residential mortgage		-			-
Commercial real estate		9,224			22,489
Commercial construction		123			1,401
Commercial non-real estate		17			15
Commercial unsecured		33			49
Consumer real estate		731			1,406
Consumer non-real estate		26			28
Total performing TDR loans accounted for on an accrual basis	$	10,154		$	25,388
Percentage of total loans, net		2.1	%		4.8	%

The following table presents a roll forward of performing TDR loans for the nine months ended September 30, 2012:

Performing TDRs	Beginning Balance		Additions (1)		Charge- offs (2)		Other (3)			Ending Balance
	(In Thousands)
September 30, 2012
Residential mortgage	$	-	$	-	$	-	$	-		$	-
Commercial		23,954		1,977		-		(16,535	)		9,396
Consumer		1,434		597		-		(1,273	)		758
Total	$	25,388	$	2,574	$	-	$	(17,808	)	$	10,154

Includes new TDRs and increases to existing TDRs.

Post modification charge-offs.

Includes principal payments, paydowns and performing loans previously restructured at market rates that are no longer reported as TDRs.

The following table presents a roll forward of non-performing TDR loans for the nine months ended September 30, 2012:

Non-Performing TDRs	Beginning Balance		Additions (1)		Charge- offs (2)			Other (3)			Ending Balance
	(In Thousands)
September 30, 2012
Residential mortgage	$	414	$	-	$	-		$	(414	)	$	-
Commercial		20,699		12,584		(4,082	)		(9,173	)		20,028
Consumer		304		-		-			166			470
Total	$	21,417	$	12,584	$	(4,082	)	$	(9,421	)	$	20,498

Includes new TDRs and increases to existing TDRs.

Post modification charge-offs.

Includes principal payments, paydowns and loans previously designated as non-performing that are now current and performing in compliance with their modified terms.

During the nine months ended September 30, 2012, one loan in the amount of $174,000 that was modified as a TDR and listed as an addition in the tables above, subsequently defaulted during the period.

In determination of the allowance for loan losses, the Bank considers TDRs and subsequent defaults in restructuring in its estimate. As a result, the allowance may be increased, adjustments may be made in the allocation of the allowance, or charge-offs may be taken to further writedown the carrying value of the loan.

The Bank’s primary objective in granting concessions to borrowers having financial difficulties is an attempt to protect as much of its investment as possible. The Bank faces significant challenges when working with borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption periods. While borrowers may experience deterioration in their financial condition, many continue to be creditworthy customers who have the willingness and capacity to repay their debts. In such cases, the Bank finds it mutually beneficial to work constructively with its borrowers, and that prudent restructurings are often in the best interest of the Bank and the borrower.

The Bank offers a variety of TDR programs on a loan-by-loan basis in which, for economic or legal reasons related to an individual borrower’s financial condition, it grants a concession to the borrower that would not otherwise be considered. The restructuring of a troubled loan may include, but is not limited to any one or combination of the following: a modification of the loan terms such as a reduction of the contractual interest rate, principal, payment amount or accrued interest; an extension of the maturity date at a stated interest rate lower than the current market rate for a new debt with similar risks; a change in payment type, e.g. from principal and interest, to interest only with all principal and interest due at maturity; a substitution or acceptance of additional collateral; and a substitution or addition of new debtors for the original borrower.

The Bank’s restructuring success includes but is not limited to any one or combination of the following: improves the prospects for repayment of principal and interest; reduces the prospects of further write downs and charge-offs; reduces the prospects of potential additional foreclosures; helps borrowers to maintain a creditworthy status; and ultimately will reduce the volume of classified, criticized and/or non-accrual loans.

The Bank identifies loans for potential restructuring on a loan-by-loan basis using a variety of sources which may include, but is not limited to any one or combination of the following: being approached or contacted by the borrower to modify loan terms; review of borrower’s financial statements indicates borrower may be experiencing financial difficulties; past due payment reports; loans extending past their stated maturity date; and non-accrual loan reports.

On a loan-by-loan basis, the Bank restructures loans that were either on non-accrual basis prior to restructuring or on accrual basis prior to restructuring. If a loan was on nonaccrual basis prior to restructuring, it remains on nonaccrual basis until the borrower has demonstrated a willingness and ability to meet the terms and conditions of the restructuring and to make the restructured loan payments, generally for a period of at least six months. The Bank has not immediately placed any restructured loan on accrual status that was on nonaccrual status prior to restructuring.

If a restructured loan was on accrual basis prior to restructuring and the Bank expects the borrower to perform to the terms and conditions of the loan after restructuring (i.e. the loan was current, on accrual basis, and the borrower has the ability to make the restructured loan payments), the loan remains on an accrual basis and placement on nonaccrual is not required. The Bank has performed restructurings on certain troubled loan workouts, whereby existing loans are restructured into a multiple note structure (i.e., Note A and Note B structure). The Bank separates a portion of the current outstanding debt into a new legally enforceable note (Note A) that is reasonably assured of repayment and performance according to prudently modified terms. The portion of the debt that is not reasonably assured of repayment (Note B) is adversely classified and charged-off as appropriate.

The following table includes the amount of multiple note restructures for certain commercial real estate loan workouts at September 30, 2012 and December 31, 2011, respectively:

	September 30, 2012		December 31, 2011
	(In thousands)
Note A Structure
Commercial real estate (1)	$	4,368	$	3,832
Note B Structure
Commercial real estate (2)		2,129		1,796
Total	$	6,497	$	5,628

Note A may be placed back on accrual status based on sustained historical payment performance, generally six months.

Note B is immediately charged-off upon restructuring; however, payment in full is due at maturity of the note.

During the nine months ended September 30, 2012, interest income was reduced by approximately $103,000 as a result of multiple note restructures.

The benefit of this workout strategy is for the A note to remain a performing asset for which the borrower has the willingness and ability to meet the restructured payment terms and conditions. In addition, this workout strategy reduces the prospects of further write downs and charge offs, and also reduces the prospects of a potential foreclosure. Following this restructuring, the Note A credit classification generally improves from “substandard” to “pass”.

The general terms of the new loans restructured under the Note A and Note B structure differ as follows:

Note A : First lien position; fixed or adjustable current market interest rate; fixed month term to maturity; payments – interest only to maturity, or full principal and interest to maturity. Note A is underwritten in accordance with the Bank’s customary underwriting standards and is on an accrual basis.

Note B : Second lien position; fixed or adjustable below current market interest rate; fixed month term to maturity; payments – due in full at maturity. Note B is underwritten in accordance with the Bank’s customary underwriting standards, except for the below market interest rate and payment terms, and is on a nonaccrual basis.

Note 8. Other Real Estate Owned. The following table reflects the changes in other real estate owned (“OREO”) during the nine months ended September 30, 2012 and 2011:

											Transfer to
	Beginning							Fair Value			Premises and			End
	of Period		Additions		Sales, net			Adjustments			Equipment			of Period
	(In thousands)
September 30, 2012
OREO	$	17,005	$	7,933	$	(4,830	)	$	(2,105	)	$	-		$	18,003
September 30, 2011
OREO	$	11,616	$	8,513	$	(4,738	)	$	(1,754	)	$	(751	)	$	12,886

The fair value adjustments made to OREO were done in order to adjust the carrying values of these properties to their estimated fair market values. In most cases, the estimated fair market values are derived from an initial appraisal, an updated appraisal or other forms of internal evaluations. In certain instances when a listing agreement is renewed for a lesser amount, management will adjust the recorded estimated fair value of the subject property accordingly. Additionally, in certain instances when the Bank receives an offer to purchase near the end of a quarterly accounting period for less than the current carrying value and the sale does not consummate until the next accounting period, management will adjust the recorded estimated fair value of the subject property accordingly.

Note 9. Fair Value Measurement . Fair value is defined as the price that would be received on the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy prioritizes the inputs of valuation techniques used to measure fair value of nonfinancial assets and liabilities. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of the market observability of the fair value measurement. In order to determine the fair value, the Bank must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the Bank to define the inputs for fair value and level of hierarchy. Outlined below is the application of the fair value hierarchy to the Bank’s financial assets that are carried at fair value.

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

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

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

Assets measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011:

	Fair Value		Quoted Prices In Active Markets for Identical Assets		Significant Observable Inputs-Other		Significant Unobservable Inputs
	(In thousands)
Description	9/30/12		(Level 1)		(Level 2)		(Level 3)
Securities available for sale:
Mortgage-backed securities	$	148,244	$	-	$	148,244	$	-
Municipal securities		24,471				24,471
Total September 30, 2012	$	172,715	$	-	$	172,715	$	-

Description	12/31/11		(Level 1)		(Level 2)		(Level 3)
Securities available for sale:
Mortgage-backed securities	$	138,515	$	-	$	138,515	$	-
Total December 31, 2011	$	138,515	$	-	$	138,515	$	-

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

Assets measured at fair value on a non-recurring basis as of September 30, 2012 and December 31, 2011:

	Fair Value		Quoted Prices In Active Markets for Identical Assets		Significant Observable Inputs-Other		Significant Unobservable Inputs
	(In thousands)
Description	9/30/12		(Level 1)		(Level 2)		(Level 3)
Impaired loans, net (1)	$	85,686	$	-	$	85,686	$	-
Other real estate owned		18,003		-		-		18,003
Total September 30, 2012	$	103,689	$	-	$	85,686	$	18,003

Description	12/31/11		(Level 1)		(Level 2)		(Level 3)
Impaired loans, net (1)	$	77,279	$	-	$	77,279	$	-
Other real estate owned		17,005		-		-		17,005
Total December 31, 2011	$	94,284	$	-	$	77,279	$	17,005

Net of allowance for loan and lease losses. Includes $63.5 million and $53.2 million of loans identified as impaired at September 30, 2012 and December 31, 2011, respectively, even though a calculated impairment analysis resulted in no impairment loss recognition.

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

OREO is recorded at lower of cost or fair value upon transfer of the loans to foreclosed assets, based on the appraised market value of the property. OREO is reviewed quarterly and values are adjusted as determined appropriate. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When an appraised value is not available or management determines the fair value of the collateral is impaired below the appraised value and there is no observable market price, the Company classifies the foreclosed asset as non-recurring Level 3. Fair value adjustments of $304,443 and $2,105,479 were made to OREO during the three and nine months ended September 30, 2012, compared to $900,627 and $1,754,416 made during the three and nine months ended September 30, 2011.

Net gains and losses realized on sales of OREO and included in earnings for the three and nine months ended September 30, 2012 and 2011 are reported in other revenues as follows:

Three Months

Ended

9/30/12

Three Months

Ended

9/30/11

Nine Months

Ended

9/30/12

Nine Months

Ended

9/30/11

Net losses on sales of other real estate owned

(56,176

)

(15,710

)

(132,197

)

(44,418

)

No liabilities were measured at fair value on a recurring or non-recurring basis at September 30, 2012 or December 31, 2011.

Note 10. Fair Value of Financial Instruments. The following table represents the recorded carrying values and estimated fair values of the Company’s financial instruments at September 30, 2012 and December 31, 2011:

	September 30, 2012				December 31, 2011
	Estimated		Carrying		Estimated		Carrying
	Fair Value		Amount		Fair Value		Amount
	(In thousands)
Financial assets:
Cash and due from banks	$	11,480	$	11,480	$	14,298	$	14,298
Interest-bearing deposits in other banks		6,031		6,031		18,476		18,476
Investment securities available for sale		172,715		172,715		138,515		138,515
Loans and leases, net		488,226		476,477		529,736		525,202
Stock in Federal Home Loan Bank of Atlanta		1,634		1,634		1,887		1,887
Accrued interest receivable		2,409		2,409		2,210		2,210

	September 30, 2012				December 31, 2011
	Estimated		Carrying		Estimated		Carrying
	Fair Value		Amount		Fair Value		Amount
	(In thousands)
Financial liabilities:
Deposits	$	611,739	$	609,501	$	648,403	$	642,617
Borrowed money:
Repurchase agreements		1,974		1,974		2,096		2,096
Junior subordinated debentures		10,310		10,310		10,310		10,310

Fair values have been estimated using data which management considers as the best available, and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimation methodologies used by the Bank were as follows:

Cash and Due from Banks and Interest –Bearing Deposits in Other Banks. The carrying amounts for cash and due from banks and interest bearing deposits in other banks approximate their fair value because of the short maturities of these financial instruments.

Investment Securities Available for Sale. The estimated fair value of investment securities available for sale is provided in Note 4 above of Notes to Consolidated Financial Statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans and Leases, Net. Fair values are estimated for portfolios of loans and leases with similar financial characteristics, such as residential mortgage. Loans and leases are segregated by type of loan, fixed and variable interest rate terms. The fair value of each category is estimated by discounting scheduled future cash flows using current interest rates offered on loans or leases with similar characteristics. Fair values for impaired loans and leases are estimated based on discounted cash flows or underlying collateral values, where applicable.

Stock in Federal Home Loan Bank of Atlanta. The fair value for FHLB stock approximates carrying value, based on the redemption provisions of the Federal Home Loan Bank.

Deposits. The fair value of demand deposits is the amount payable on demand at the reporting date. The fair values of certificates of deposits are estimated by discounting scheduled future cash flows using rates currently offered for similar instruments with similar remaining maturities.

Accrued Interest Receivable, Repurchase Agreements and Junior Subordinated Debentures. The carrying amount of accrued interest receivable, repurchase agreements, and junior subordinated debentures approximates fair value because of the short maturities of these instruments.

Financial Instruments with Off-Balance Sheet Risk. With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments.

Note 11. Deposits. The following table presents the distribution of the Bank’s deposit accounts as of September 30, 2012 and December 31, 2011:

	9/30/12		12/31/11
	(In thousands)
Demand accounts:
Non-interest bearing checking	$	95,463	$	$98,969
Interest bearing checking		142,405		130,002
Money market		30,375		14,748
Savings accounts		30,612		28,989
Certificate accounts		310,646		369,909
Total deposits	$	$609,501	$	$642,617

Note 12. Stock-Based Compensation. The Company had two stock-based compensation plans at September 30, 2012. The shares outstanding are for grants under the Company’s 1997 Stock Option Plan (the “1997 Plan”) and the 2008 Equity Incentive Plan (the “2008 Plan”). The 1997 Plan matured on April 8, 2008 and no additional options may be granted under the 1997 Plan. At September 30, 2012, the 1997 Plan had 58,671 granted unexercised shares, and the 2008 Plan includes 94,000 granted unexercised shares and 864,000 shares available to be granted. No restricted shares were granted under the 2008 Plan during the three and nine months ended September 30, 2012.

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

A summary of option activity under the Plans as of September 30, 2012 and 2011, and changes during the three and nine month periods ended September 30, 2012 and 2011 is presented below:

Quarter Ended September 30, 2012:	Options Outstanding			Price		Aggregate Intrinsic Value
Outstanding at December 31, 2011		166,833		$	15.26
Granted		20,000		$	4.12
Forfeited		(5,562	)	$	15.13
Exercised		-		$	-
Outstanding at March 31, 2012		181,271		$	14.03	$	(1,818,929	)
Granted		-		$	-
Forfeited		(7,000	)	$	11.67
Exercised		-		$	-
Outstanding at June 30, 2012		174,271		$	14.13	$	(1,756,525	)
Granted		-		$	-
Forfeited		(21,600	)	$	16.23
Exercised		-		$	-
Outstanding at September 30, 2012		152,671		$	13.83	$	(1,368,362	)
Vested and Exercisable at September 30, 2012		111,505		$	16.76	$	(1,325,719	)

Quarter Ended September 30, 2011:
Outstanding at December 31, 2010		181,441		$	15.60
Granted		21,000		$	5.40
Forfeited		(1,500	)	$	26.97
Exercised		-		$	-
Outstanding at March 31, 2011		200,941		$	14.45	$	(1,900,166	)
Granted		3,000		$	5.05
Forfeited		(3,000	)	$	17.41
Exercised		-		$	-
Outstanding at June 30, 2011		200,941		$	14.26	$	(2,009,778	)
Granted		-		$	-
Forfeited		(32,441	)	$	9.31
Exercised		-		$	-
Outstanding at September 30, 2011		168,500		$	15.22	$	(1,948,865	)
Vested and Exercisable at September 30, 2011		113,684		$	17.99	$	(1,629,924	)

No options were granted during either the three months ended September 30, 2012 or 2011, compared to 20,000 and 24,000 options granted during the nine months ended September 30, 2012 and 2011, respectively. The average fair value per share of options granted in the nine months ended September 30, 2012 was $1.59, compared to $2.21 in the nine months ended September 30, 2011. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model.

The following weighted-average assumptions were used for grants awarded in the three and nine months ended September 30, 2012 and 2011:

	Three Months Ended 9/30/12			Three Months Ended 9/30/11			Nine Months Ended 9/30/12			Nine Months Ended 9/30/11
Dividend growth rate		0.0	%		0.0	%		0.0	%		0.0	%
Expected volatility		0.0	%		0.0	%		37.4	%		37.8	%
Average risk-free interest rate		0.0	%		0.0	%		1.7	%		2.8	%
Expected lives - years		-			-			6			6

The following table summarizes additional information about the Company’s outstanding options and exercisable options as of September 30, 2012, including weighted-average remaining contractual term expressed in years ("Life") and weighted average exercise price (“Price”):

	Outstanding						Exercisable
Range of Exercise Price	Shares		Life		Price		Shares		Price
$ 4.12 – 10.91		71,000		8.10	$	6.87		32,334	$	8.99
$ 11.80 – 16.49		23,796		4.17	$	14.35		22,796	$	14.37
$ 17.27 – 25.07		46,625		4.57	$	20.61		45,125	$	20.58
$ 26.17 – 33.27		11,250		4.24	$	28.62		11,250	$	28.62
		152,671		6.12	$	13.83		111,505	$	16.76

A summary of nonvested option shares as of September 30, 2012 and 2011, and changes during the three and nine months ended September 30, 2012 and 2011, is presented below:

	Shares			Price
Period Ended September 30, 2012:
Nonvested at December 31, 2011		54,316		$	9.43
Granted		20,000		$	4.12
Forfeited		(2,000	)	$	12.95
Vested		(22,834	)	$	9.89
Nonvested at March 31, 2012		49,482		$	6.92
Granted		-		$	-
Forfeited		(2,666	)	$	11.91
Vested		(1,650	)	$	10.21
Nonvested at June 30, 2012		45,166		$	6.50
Granted		-		$	-
Forfeited		-		$	-
Vested		(4,000	)	$	12.66
Nonvested at September 30, 2012		41,166		$	5.91

Period Ended September 30, 2011:
Nonvested at December 31, 2010		63,116		$	13.04
Granted		21,000		$	5.40
Forfeited		-		$	-
Vested		(19,501	)	$	12.37
Nonvested at March 31, 2011		64,615		$	10.76
Granted		3,000		$	5.05
Forfeited		(1,500	)	$	9.60
Vested		(3,050	)	$	21.95
Nonvested at June 30, 2011		63,065		$	9.97
Granted		-		$	-
Forfeited		(5,333	)	$	11.20
Vested		(2,916	)	$	17.10
Nonvested at September 30, 2011		54,816		$	9.47

There were no income tax benefits realized from the exercise of stock options for the three and nine months ended September 30, 2012 or 2011. There was no intrinsic value for options exercised during the three and nine months ended September 30, 2012 or 2011, as no options were exercised during the respective periods.

Net compensation benefit credited to income for the Plans was $55,017 and $57,120 for the three and nine months ended September 30, 2012, compared to net compensation benefit credited to income of $47,819 for the three months ended September 30, 2011 and net compensation cost charged against income of $1,353 for the nine months ended September 30, 2011. Total recapture credits against compensation expense due to forfeited options was $69,204 and $107,322 for the three and nine months ended September 30, 2012, compared to $72,357 and $79,862 for the three and nine months ended September 30, 2011. As of September 30, 2012, total unrecognized compensation cost on granted unexercised shares was $61,718, and is expected to be recognized during the next four years.

The fair value compensation cost recognition provisions for share-based payments are different from the recognition provisions of the intrinsic value method for recording compensation cost. The following table reflects the impact of fair value compensation cost recognition on income before income taxes, net income, basic earnings per share and diluted earnings per share for the three and nine month periods ended September 30, 2012 and 2011:

	Three Months Ended 9/30/12		Three Months Ended 9/30/11		Nine Months Ended 9/30/12		Nine Months Ended 9/30/11
Increase (decrease) net income before income taxes	$	55,017	$	47,819	$	57,120	$	(1,353	)
Increase (decrease) net income	$	55,017	$	48,015	$	57,318	$	(328	)
Increase (decrease) basic earnings per share	$	0.01	$	0.00	$	0.01	$	0.00
Increase (decrease) diluted earnings per share	$	0.01	$	0.00	$	0.01	$	0.00

Note 13. Recent Accounting Pronouncements. The following summarizes recent accounting pronouncements and their expected impact on the Company.

In December 2011, the Financial Accounting Standards Board (FASB) issued new guidance on Derecognition of in Substance Real Estate – a Scope Clarification. This guidance provides clarification for when a parent company ceases to have a controlling financial interest in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt. This guidance is effective for reporting periods beginning after September 15, 2012. The Company will evaluate the impact this guidance may have on its consolidated financial statements.

In December 2011, the FASB issued new guidance on Disclosures about Offsetting Assets and Liabilities. This guidance requires an entity to disclose information about offsetting (netting assets and liabilities) and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. This guidance is effective for reporting periods beginning on or after January 1, 2013. The Company will evaluate the impact this guidance may have on its consolidated financial statements.

In July 2012, the FASB issued new guidance on Testing Indefinite-Lived Intangible Assets for Impairment. This guidance will allow an entity to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. Under this guidance, an entity would not be required to calculate the fair value of an indefinite-lived intangible asset unless the entity determines, based on qualitative assessment, that it is not more likely than not, the indefinite-lived intangible asset is impaired. The guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. The Company will evaluate the impact this guidance may have on its consolidated financial statements.

In October 2012, the FASB issued an update on Technical Corrections and Improvements. The types of issues the FASB considered through this update are changes to clarify the Accounting Standards Codification or correct unintended application of guidance that are not expected to have a significant effect on current accounting practice or create a significant administrative cost to most entities. This update also includes more substantive limited-scope improvements that represent narrow and incremental improvements in U.S. GAAP and are not purely technical corrections. Maintenance updates include nonsubstantive corrections to the Codification, such as editorial corrections, various types of link-related changes and changes to source fragment information. For public entities, this update will be effective for fiscal periods beginning after December 15, 2012. The Company will evaluate the impact this update may have on its consolidated financial statements.

In October 2012, the FASB issued new guidance on Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution. This guidance addresses the diversity in practice about how to interpret the terms on the same basis and contractual limitations when subsequently measuring an indemnification asset recognized in a government-assisted (Federal Deposit Insurance Corporation or National Credit Union Administration) acquisition of a financial institution that includes a loss-sharing agreement (indemnification agreement). This guidance is effective for fiscal years and interim periods beginning on or after December 15, 2012. The Company will evaluate the impact this guidance may have on its consolidated financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

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

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

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

Comparison of Financial Condition at September 30, 2012 and December 31, 2011. Total assets declined to $717.2 million at September 30, 2012, from $746.9 million at December 31, 2011. Earning assets declined to $654.3 million at September 30, 2012, from $681.5 million at December 31, 2011, reflecting the net change in the composition of earning assets, as discussed below. The ratio of earning assets to total assets was 91.24% at both September 30, 2012 and December 31, 2011.

Interest-bearing overnight deposits in financial institutions declined to $6.0 million at September 30, 2012, from $18.5 million at December 31, 2011. Overnight deposits are available to fund securities purchases, loan originations, deposit withdrawals, liquidity management activities and daily operations of the Bank.

Investment securities available for sale increased to $172.7 million at September 30, 2012, from $138.5 million at December 31, 2011, reflecting the net of purchases, sales, principal repayments, securitizations of certain mortgage loans, an increase in unrealized holding gains and the net accretion of premiums and discounts. During the nine months ended September 30, 2012, there were $38.6 million of purchases, $33.0 million of sales, $17.0 million of principal repayments, $41.0 million of securitizations, a $4.7 million increase in unrealized holding gains and $160,000 of net accretion of premiums and discounts. The Bank sells investment securities and securitizes mortgage loans held for sale into mortgage-backed securities in order to support a more balanced sensitivity to future interest rate changes and to support adequate liquidity levels. During the nine months ended September 30, 2012, the Bank implemented a strategy to diversify its investment portfolio through the purchase of certain tax-exempt municipal securities. At September 30, 2012, the balance of the municipal securities portfolio was $24.5 million, compared to no municipal securities held at December 31, 2011. See “Note 4. Investment Securities” of “Notes to Consolidated Financial Statements (Unaudited)” for additional disclosure information.

Loans held for sale declined to $700,000 at September 30, 2012, from $6.4 million at December 31, 2011, reflecting the net of originations, sales, net realized gains and securitizations into mortgage-backed securities. During the nine months ended September 30, 2012, there were $58.5 million of originations, $24.7 million of sales, $1.4 million of net realized gains and $41.0 million of securitizations. Proceeds from loan sales are primarily used to fund liquidity needs of the Bank, including loan originations, deposit withdrawals, repayment of borrowings, investment security purchases and general banking operations. Loans serviced for others increased to $329.0 million at September 30, 2012, from $319.4 million at December 31, 2011.

Loans and leases receivable held for investment, net of deferred loan fees, declined to $490.8 million at September 30, 2012, from $534.0 million at December 31, 2011, reflecting principal payments net of originations, net charge offs and transfers to OREO. During the nine months ended September 30, 2012, there were $30.5 million of principal payments net of originations, $4.8 million of net charge offs and $7.9 million of transfers to OREO. In addition, a portion of funds from principal repayments on loans held for investment was used to support the liquidity needs of the Bank.

Total loans on non-accrual status and restructured loans (TDRs) on non-accrual status declined to $34.8 million at September 30, 2012, from $43.0 million at December 31, 2011. Loans on non-accrual status declined to $14.3 million at September 30, 2012, from $21.6 million at December 31, 2011. TDRs on non-accrual status declined to $20.5 million at September 30, 2012, from $21.4 million at December 31, 2011. Performing TDRs on full accrual status declined to $10.2 million at September 30, 2012, from $25.4 million at December 31, 2011. Certain performing TDRs have been restored to full accrual status, as they need not continue to be reported as a restructure in calendar years after the year in which the restructuring took place, if the loan is in compliance with its modified terms and yields a market rate.

The economy continues to present a challenging credit environment for the Bank and its customers. Economic pressure continues to impact market values of housing and other real estate property in the Bank’s market area and credit quality of certain borrowers. Management believes it has thoroughly evaluated its non-performing loans and they are either well collateralized or adequately reserved. However, there can be no assurance in the future that regulators, increased risks in the loan portfolio, adverse changes in economic conditions or other factors will not require further adjustments to the allowance for credit losses.

Aside from the loans defined as non-accrual, over 90 days past due, classified, or restructured, there were no loans at September 30, 2012, 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 their current loan repayment terms. There were $1.9 million of loans that were accruing interest and contractually over 90 days past due at September 30, 2012. These primarily represent loans that have matured and are in process of renewal. Additional gross interest income of approximately $38,000 was recorded on these loans as of September 30, 2012.

Loans are generally placed on non-accrual status, and accrued but unpaid interest is reversed, when in management’s judgment, it is determined that the collectability of interest, but not necessarily principal, is doubtful. Generally, this occurs when payment is delinquent in excess of 90 days. Consumer loans that have become more than 180 days past due are generally charged off or a specific allowance may be provided for any expected loss. All other loans are charged off when management concludes that they are uncollectible.

Based on an impairment analysis of the Bank’s loan and lease portfolio, there were $88.5 million of loans classified as impaired at September 30, 2012, net of $7.0 million in write-downs, compared to $78.9 million classified as impaired at December 31, 2011, net of $13.4 million in write-downs. At September 30, 2012 and December 31, 2011, the allowance for loan and lease losses included $2.8 million and $1.6 million specifically provided for impaired loans, respectively. 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. All collateral-dependent loans are measured for impairment based on the fair value of the collateral, while uncollateralized loans and other loans determined not to be collateral dependent are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payments status, borrowers’ financial data and borrowers’ operating factors such as cash flows, operating income or loss, and various other matters.

See “Note 5. Loans Receivable”, “Note 6. Allowance for Credit Losses” and “Note 7. Troubled Debt Restructurings” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Other real estate owned acquired from foreclosures increased to $18.0 million at September 30, 2012, from $17.0 million at December 31, 2011, reflecting the net of additions, disposals and fair value adjustments. During the nine months ended September 30, 2012 there were $7.9 million of additions, $4.8 million of disposals, and $2.1 million of fair value adjustments. Other real estate owned consists of residential and commercial properties, developed lots and raw land. The Bank believes the adjusted carrying values of these properties are representative of their fair market values, although there can be no assurances that the ultimate sales will be equal to or greater than the carrying values. See “Note 8. Other Real Estate Owned” and “Note 9. Fair Value Measurement” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Total deposits declined to $609.5 million at September 30, 2012, from $642.6 million at December 31, 2011. Demand accounts (personal and business checking accounts and money market accounts) increased to $268.2 million at September 30, 2012, from $243.7 million at December 31, 2011. Time deposits declined to $310.6 million at September 30, 2012, from $369.9 million at December 31, 2011. The Bank attempts to manage its cost of deposits by monitoring the volume and rates paid on maturing certificates of deposits in relationship to current funding needs and market interest rates. The Bank did not renew certain higher rate maturing time deposits during the nine months ended September 30, 2012 and was able to reprice new and maturing time deposits at lower rates. See “Note 11. Deposits” of “Notes to Consolidated Financial Statements (Unaudited)” and “Interest Expense” below for additional information regarding deposits and the cost of funds.

Borrowed money consisting of repurchase agreements declined to $2.0 million at September 30, 2012, from $2.1 million at December 31, 2011. Repurchase agreements represent funds held in cash management accounts for commercial banking customers. Effective November 1, 2012 the Bank will discontinue the repurchase agreement program. Subsequently, the Bank will sweep commercial banking customers excess cash funds into an interest bearing deposit account.

There were no FHLB advances outstanding at September 30, 2012 or December 31, 2011. The Bank may use lower costing FHLB borrowings as a funding source, providing an effective means of managing its overall cost of funds. At September 30, 2012, the Bank had $148.5 million of credit availability with the FHLB, of which there was lendable collateral value totaling $61.7 million. Additional collateral would be required in order to access total borrowings up to the credit availability limit. In addition, the Bank had $40.0 million of pre-approved but unused lines of credit.

Stockholders' equity increased to $88.1 million at September 30, 2012, from $84.1 million at December 31, 2011, reflecting the net effect of earnings and changes in accumulated other comprehensive income. The equity to assets ratio was 12.29% at September 30, 2012, compared to 11.26% at December 31, 2011. See "Consolidated Statements of Changes in Stockholders' Equity" for additional information.

Accumulated other comprehensive income increased to $5.8 million at September 30, 2012, from $3.7 million at December 31, 2011, reflecting the net unrealized gains in the available for sale investment securities portfolio based on current market prices. See “Note 3. Comprehensive Income” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

There were 1,502,951 treasury shares held totaling $32.0 million at both September 30, 2012 and December 31, 2011. Treasury shares are used for general purposes including the exercise of stock options and providing shares for potential future stock splits.

The Bank is subject to various regulatory capital requirements administered by its federal and state banking agencies. During the nine months ended September 30, 2012, $10.0 million of new capital in the form of additional paid-in-capital was infused into the Bank from the Company, resulting from an inter-company income tax strategy. The Bank’s regulatory capital ratios as of September 30, 2012 have increased significantly from December 31, 2011 as indicated below.

	9/30/12			12/31/11
First South Bank Regulatory Capital	Ratio			Ratio
Total Risk-Based Capital Ratio		18.65	%		15.22	%
Tier 1 Risk-Based Capital Ratio		17.38	%		13.95	%
Tier 1 Leverage Ratio		11.94	%		10.02	%

Comparison of Operating Results – Three and Nine months ended September 30, 2012 and 2011. Net income for the three and nine months ended September 30, 2012 increased to $966,000 and $1.9 million, from $403,000 and $1.1 million for the three and nine months ended September 30, 2011. Diluted earnings per share were $0.10 and $0.20 for the three and nine months ended September 30, 2012, compared to $0.04 and $0.11 per share for the three and nine months ended September 30, 2011.

Net earnings during the three and nine months ended September 30, 2012 and 2011 were influenced by the amount of provisions for credit losses necessary to maintain the allowance for loan and lease losses at an adequate level; a decline in the volume of average earning assets; expenses attributable to other real estate owned properties; while being partially offset by a reduction in interest expense and gains on mortgage loan and investment securities sales. The current economy continues to present a challenging credit environment for the Bank and for some of its customers. As the Bank addresses and manages through these challenges, it remains focused on long-term strategies. These strategies include remediating problem assets, maintaining adequate levels of capital and liquidity, improving efficiency in operations, building core customer relationships and improving franchise and stockholder value. The Bank continues to maintain a strong capital position in excess of the well-capitalized regulatory guidelines, and combined with strengthening of the allowance for credit losses provides the Bank with a strong foundation from which to grow as economic conditions improve.

Key performance ratios are return on average assets (ROA), return on average equity (ROE) and efficiency. ROA improved to .53% and .34% for the three and nine months ended September 30, 2012, from .21% and .19% for the three and nine months ended September 30, 2011. ROE improved to 4.42% and 2.97% for the three and nine months ended September 30, 2012, from 1.97% and 1.83% for the three and nine months ended September 30, 2011. The efficiency ratio was 64.78% and 74.85% for the three and nine months ended September 30, 2012, compared to 67.77% and 67.47% for the three and nine months ended September 30, 2011, reflecting the Bank’s efforts on improving its operating efficiency by managing net interest income, growing non-interest income and controlling operating expenses.

Interest Income. Interest income declined to $8.3 million and $26.1 million for the three and nine months ended September 30, 2012, from $9.9 million and $29.9 million for the three and nine months ended September 30, 2011. The reduction in the amount of interest income is due primarily to lower interest rates during the comparative reporting periods, and a decline in the volume of average interest-earning assets. Average interest-earning assets declined to $664.6 million and $671.8 million for the three and nine months ended September 30, 2012, from $699.0 million and $704.1 million for the three and nine months ended September 30, 2011. The reduction in average interest-earning assets reflects the net effect of the decrease in loans and leases receivable; sales, purchases and principal payments on investment securities; and the volume of other real estate owned and non-performing loans discussed above. The yield on average interest-earning assets declined to 5.06% and 5.19% for the three and nine months ended September 30, 2012, from 5.64% and 5.67% for the three and nine months ended September 30, 2011. The yield on average interest-earning assets has also been impacted by the decline in interest rates and average interest-earning assets during the comparative reporting periods.

Interest Expense. Interest expense declined to $1.1 million and $3.9 million for the three and nine months ended September 30, 2012, from $1.9 million and $5.9 million for the three and nine months ended September 30, 2011, reflecting a decline in interest rates between the comparative reporting periods and a decline in the volume of average interest-bearing liabilities. The cost of funds improved to .69% and .80% for the three and nine months ended September 30, 2012, from 1.08% and 1.13% for the three and nine months ended September 30, 2011. The Company was able to improve its cost of funds by a combination of the growth in lower costing demand accounts, pricing new time deposits and repricing of maturing time deposits within the lower interest rate environment. Average deposits and borrowings declined to $635.8 million and $644.7 million for the three and nine months ended September 30, 2012, from $685.3 million and $698.9 million for the three and nine months ended September 30, 2011.

Net Interest Income . Net interest income declined to $7.2 million and $22.2 million for the three and nine months ended September 30, 2012, from $8.0 million and $24.0 million for the three and nine months ended September 30, 2011. The interest rate spread (the difference between the yield on average earning assets and the cost of average deposits and borrowings) declined to 4.37% and 4.39% for the three and nine months ended September 30, 2012, from to 4.56% and 4.54% for the three and nine months ended September 30, 2011. The tax equivalent net yield on interest-earning assets (net interest income divided by average interest-earning assets) declined to 4.40% and 4.43% for the three and nine months ended September 30, 2012, from 4.58% and 4.54% for the three and nine months ended September 30, 2011 . The changes in interest rate spread and net yield on interest-earning assets is a result of the interest rate environment and volume levels of interest-earning assets and interest-bearing liabilities outstanding during the comparative reporting periods.

The following tables contain information relating to the Company’s average statement of financial condition and reflect the yield on average earning assets and the average cost of funds for the three and nine months ended September 30, 2012 and 2011. Average balances are derived from month end balances. The Company does not believe that using month end balances rather than average daily balances has caused any material difference in the information presented. The average loan balances listed in interest earning assets do not include nonaccrual loan balances. The interest rate spread r epresents the difference between the yield on earning assets and the average cost of funds. The net yield on earning assets represents net interest income divided by average earning assets.

Tax equivalent yields related to certain investment securities exempt from federal income tax are stated on a fully taxable basis, using a 34% federal tax rate and reduced by a disallowed portion of the tax exempt interest income.

Yield/Cost Analysis	Quarter Ended September 30, 2012							Quarter Ended September 30, 2011
					(Dollars in thousands)
					Average							Average
	Average				Yield/			Average				Yield/
	Balance		Interest		Cost			Balance		Interest		Cost
Interest earning assets:
Loans receivable	$	483,370	$	6,903		5.71	%	$	555,517	$	8,582		6.18	%
Investments and deposits		181,239		1,442		3.31	%(1)		143,467		1,279		3.57	%
Total earning assets		664,609		8,345		5.06	%		698,984		9,861		5.64	%
Nonearning assets		65,599							75,399
Total assets	$	730,204						$	774,383

Interest bearing liabilities:
Deposits	$	526,938		1,002		.76	%	$	571,208		1,767		1.24	%
Borrowings		3,468		2		.23	%		2,301		2		.35	%
Junior subordinated debentures		10,310		92		3.57	%		10,310		83		3.22	%
Total interest-bearing liabilities		540,716		1,096		.81	%		583,819		1,852		1.27	%
Noninterest bearing demand deposits		95,057		0		.00	%		101,495		0		.00	%
Total sources of funds		635,773		1,096		.69	%		685,314		1,852		1.08	%
Other liabilities and stockholders’ equity:
Other liabilities		6,994							7,312
Stockholders' equity		87,437							81,757
Total liabilities and stockholders' equity	$	730,204						$	774,383
Net interest income			$	7,249						$	8,009
Interest rate spread						4.37	%						4.56	%
Net yield on earning assets						4.40	%(1)						4.58	%
Ratio of earning assets to interest bearing liabilities						122.91	%						119.73	%

Yield/Cost Analysis	Nine Months Ended September 30, 2012							Nine Months Ended September 30, 2011
					(Dollars in thousands)
					Average							Average
	Average				Yield/			Average				Yield/
	Balance		Interest		Cost			Balance		Interest		Cost
Interest earning assets:
Loans receivable	$	501,699	$	22,017		5.85	%	$	564,979	$	26,312		6.21	%
Investments and deposits		170,096		4,060		3.25	%(1)		139,126		3,628		3.48	%
Total earning assets		671,795		26,077		5.19	%		704,105		29,940		5.67	%
Nonearning assets		65,889							82,583
Total assets	$	737,684						$	786,688

Interest bearing liabilities:
Deposits	$	535,908		3,573		.89	%	$	585,495		5,669		1.29	%
Borrowings		2,449		4		.22	%		3,166		31		1.31	%
Junior subordinated debentures		10,310		275		3.56	%		10,310		248		3.21	%
Total interest-bearing liabilities		548,667		3,852		.94	%		598,971		5,948		1.32	%
Noninterest bearing demand deposits		96,042		0		.00	%		99,947		0		.00	%
Total sources of funds		644,709		3,852		.80	%		698,918		5,948		1.13	%
Other liabilities and stockholders’ equity:
Other liabilities		6,923							6,923
Stockholders' equity		80,847							80,847
Total liabilities and stockholders' equity	$	732,479						$	786,688
Net interest income			$	22,225						$	23,992
Interest rate spread						4.39	%						4.54	%
Net yield on earning assets						4.43	%(1)						4.54	%
Ratio of earning assets to interest bearing liabilities						122.44	%						117.55	%

(1)

Shown as a tax-adjusted yield

Provision for Credit Losses. The Bank's methodology for determining its provision for credit losses includes amounts specifically allocated to credits that are individually determined to be impaired, as well as general provisions allocated to groups of loans that have not been individually assessed for impairment. The Bank recorded $2.0 million and $4.6 million of provisions for credit losses in the three and nine months ended September 30, 2012, compared to $2.6 million and $8.2 million in the three and nine months ended September 30, 2011. The provision for credit losses is necessary to maintain the allowance for credit losses at a level that management believes is adequate to absorb probable future losses in the loan portfolio. See “Note 6. Allowance for Credit Losses” of “Notes to Consolidated Financial Statements (Unaudited)” and “Allowance for Credit Losses” and “Critical Accounting Policies - Loan Impairment and Allowance for Credit Losses” below for additional disclosure information.

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

The Bank uses various modeling, calculation methods and estimation tools for measuring credit risk and performing impairment analysis, which is the basis used in developing the allowance for credit losses. The factors supporting the allowance do not diminish the fact that the entire allowance for credit losses is available to absorb probable losses in both the loan and leases portfolio and in unfunded loan commitments. The Bank’s principal focus is on the adequacy of the total allowance for credit losses. Based on the overall credit quality of the loan and lease receivable portfolio, management believes the Bank has established the allowance for credit losses pursuant to generally accepted accounting principles, and has taken into account the views of its regulators and the current economic environment. Management reassesses the information upon which it bases the allowance for credit losses quarterly and believes their accounting decisions remain accurate. However, there can be no assurance in the future that regulators, increased risks in the loan and lease portfolio, changes in economic conditions and other factors will not require additional adjustments to the allowance for credit losses.

The allowance for credit losses was $15.3 million at September 30, 2012, compared to $15.4 million December 31, 2011, reflecting the net of provisions for credit losses and net charge offs. During the nine months ended September 30, 2012, there were $4.6 million of provisions for credit losses and $4.8 million of net charge offs . The ratio of the allowance for credit losses to loans and leases was 3.10% at September 30, 2012, compared to 2.85% at December 31, 2011. See “Note 6. Allowance for Credit Losses” and “Note 9. Fair Value Measurement” of “Notes to Consolidated Financial Statements (Unaudited)”and “Critical Accounting Policies - Loan Impairment and Allowance for Credit Losses” below for additional disclosure information.

Noninterest Income. Noninterest income increased to $2.7 million and $8.5 million for the three and nine months ended September 30, 2012, from $2.3 million and $6.8 million for the three and nine months ended September 30, 2011. Noninterest income consists of fees, service charges and servicing fees earned on loans, service charges and insufficient funds fees collected on deposit accounts, net gains from loan and securities sales and other miscellaneous income.

The Bank strives to maintain a consistent level of noninterest income across both loan and deposit service offerings. Fees, service charges and loan servicing fees collected were $1.6 million and $5.0 million for the three and nine months ended September 30, 2012, compared to $1.7 million and $5.1 million for the three and nine months ended September 30, 2011. Fees, service charges and loan servicing fees earned during each period are influenced by the volume of loans receivable and deposits outstanding, the volume of the various types of loan and deposit account transactions processed, the volume of loans serviced for others and the collection of related fees and service charges.

Gains on sales of mortgage loans held for sale increased to $858,000 and $1.4 million for the three and nine months ended September 30, 2012, from $165,000 and $397,000 for the three and nine months ended September 30, 2011. The Bank may sell or securitize fixed-rate residential mortgage loans to reduce interest rate and credit risk exposure, and to provide a more balanced sensitivity to future interest rate changes, while retaining certain other held for sale mortgage loans for future securitization into available for sale mortgage-backed securities. Proceeds from mortgage loan sales provide additional liquidity to support the Bank’s operating, financing and lending activities.

Gains from sales of investment securities available for sale were $28,000 and $1.5 million for the three and nine months ended September 30, 2012, compared to $204,000 and $256,000 during the three and nine months ended September 30, 2011. Proceeds from investment securities sales also provide liquidity to support the Bank’s operating, financing and lending activities.

In its efforts of mitigating nonperforming assets, the Bank recorded net losses on sales of other real estate owned properties of $56,000 and $132,000 in the three and nine months ended September 30, 2012, compared to $16,000 and $44,000 in the three and nine months ended September 30, 2011. See “Note 8. Other Real Estate Owned” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Noninterest Expense. Noninterest expense was $6.4 million and $23.3 million for the three and nine months ended September 30, 2012, compared to $7.0 million and $20.8 million for the three and nine months ended September 30, 2011. Compensation and fringe benefits, the largest component of noninterest expense, was $3.6 million and $12.2 million for the three and nine months ended September 30, 2012, compared to $3.7 million and $11.4 million for the three and nine months ended September 30, 2011. The increase during the nine months ended September 30, 2012 primarily results from accelerating the accrual of anticipated lump-sum retirement benefits payable to the former CEO upon his retirement at the end of August 2012. The Bank accrued $200,000 and $1.5 million for his lump-sum retirement benefits payable in the three and nine months ended September 30, 2012, compared to $37,000 and $112,000 accrued in the three and nine months ended September 30, 2011.

FDIC insurance premiums declined to $234,000 and $746,000 for the three and nine months ended September 30, 2012, from $388,000 and $972,000 for the three and nine months ended September 30, 2011, reflecting the decline in the volume of insured deposit account balances, and changes in the FDIC’s deposit insurance assessment calculation. The FDIC changed their deposit insurance assessment calculation during 2011 to be based on assets and Tier 1 capital rather than deposits.

Expenses attributable to valuation adjustments, renovating, maintenance and property taxes paid for the current volume of other real estate owned properties was $316,000 and $2.9 million for the three and nine months ended September 30, 2012, compared to $579,000 and $1.1 million for the three and nine months ended September 30, 2011. See “Note 8. Other Real Estate Owned” and “Note 9. Fair Value Measurement” of “Notes to Consolidated Financial Statements (Unaudited)” for additional information.

Data processing costs declined to $344,000 and $1.6 million for the three and nine months ended September 30, 2012 , from $699,000 and $1.9 million for the three and nine months ended September 30, 2011 , reflecting favorable initial pricing from a recently completed core data processing system upgrade. Upon the expiration of these pricing concessions, data processing expenses are anticipated to approximate previously reported amounts.

Other noninterest expenses including premises and equipment, advertising, repairs and maintenance, office supplies, professional fees, taxes and insurance, etc., remained relatively consistent during the respective reporting periods.

Income Taxes. Income tax expense increased to $552,000 and $1.0 million for the three and nine months ended September 30, 2012, from $256,000 and $706,000 for the three and nine months ended September 30, 2011. Income tax expense results from the volume of pretax income, tax exempt income, deductible expenses, the application of permanent and temporary differences and the statutory income tax rates in effect during each period. The effective income tax rates were 36.37% and 34.95% for the three and nine months ended September 30, 2012, compared to 38.79% and 38.82% for the three and nine months ended September 30, 2011. See “Critical Accounting Policies” below for additional information.

Liquidity and Capital Resources. Liquidity generally refers to the Bank's ability to generate adequate amounts of funds to meet its cash needs. Adequate liquidity guarantees that sufficient funds are available to meet deposit withdrawals, fund future loan commitments, maintain adequate reserve requirements, pay operating expenses, provide funds for debt service, and meet other general commitments. FDIC policy requires banks to maintain an average daily balance of liquid assets in an amount which it deems adequate to protect the safety and soundness of the bank. The FDIC currently has no specific level which it requires. At September 30, 2012, the Bank had cash, deposits in banks, investment securities and loans held for sale totaling $190.9 million, compared to $177.7 million at December 31, 2011. The Bank calculates its liquidity position under policy guidelines based on liquid assets in relationship to deposits and short-term borrowings. Based on its calculation guidelines, the Bank’s liquidity ratio increased to 28.08% at September 30, 2012, from 25.84% December 31, 2011, which management believes is adequate.

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

The FDIC requires banks to meet a minimum leverage capital requirement of Tier 1 capital (consisting of retained earnings and common stockholders’ equity, less any intangible assets) to assets ratio of 4%. The FDIC also requires banks to meet a ratio of total capital to risk-weighted assets of 8%, of which at least 4% must be in the form of Tier 1 capital. The Bank was in compliance with all regulatory capital requirements at September 30, 2012 and December 31, 2011.

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

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

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

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

Income Taxes . Deferred tax asset and liability balances are determined by application to temporary differences in 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 Arrangements. The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The Company's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

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

Item 3. Quantitative and Qualitative Disclosures about Market Risk. Smaller reporting companies are not required to provide information required by this item.

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

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

PART II. OTHER INFORMATION

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

Item 1A. Risk Factors: Smaller reporting companies are not required to provide information required by this item.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds: Not applicable

Item 3. Defaults Upon Senior Securities: Not applicable

Item 4. Mine Safety Disclosures: Not applicable.

Item 5. Other Information: Not applicable

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

Number		Title
10.18		Change-in-Control Protective Agreement between First South Bancorp, Inc., First South Bank, and Scott C. McLean dated October 27, 2012 (Incorporated herein by reference from Exhibit 10.18 to the Company’s Current Report on Form 8-K filed on October 31, 2012 (File No. 0-22219))

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

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

32		Section 1350 Certification

101		Interactive data files providing financial information from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2012, in XBRL (eXtensible Business Reporting Language)*

________________

* Pursuant to Regulation 406T of Regulation S-T, these interactive data files are furnished and not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.

SIGNATURES

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

FIRST SOUTH BANCORP, INC.

By:	/s/ Scott C. McLean	By:	/s/ Kristie W. Hawkins
	Scott C. McLean		Kristie W. Hawkins
	Executive Vice President		Controller
	Chief Financial Officer		Treasurer
	(Principal Financial Officer)		(Principal Accounting Officer)

	Date: November 8, 2012		Date: November 8, 2012