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 March 31, 2012 and December 31, 2011. Total assets increased to $750.3 million at March 31, 2012, from $746.9 million at December 31, 2011. Earning assets increased to $682.1 million at March 31, 2012, from $681.5 million at December 31, 2011, reflecting the net change in the composition of earning assets, as further discussed below. The ratio of earning assets to total assets was 90.9% at March 31, 2012, compared to 91.2% at December 31, 2011.

Interest-bearing overnight deposits in financial institutions increased to $49.1 million at March 31, 2012, from $18.5 million at December 31, 2011. Overnight deposits are available to fund loan originations, deposit withdrawals, securities purchases, liquidity management activities and daily operations of the Bank.

Mortgage-backed securities available for sale declined to $123.0 million at March 31, 2012, from $138.5 million at December 31, 2011. The Bank may sell mortgage-backed securities to support a more balanced sensitivity to future interest rate changes and may securitize mortgage loans held for sale into mortgage-backed securities to support adequate liquidity levels. During the three months ended March 31, 2012, the Bank sold $23.5 million of mortgage-backed securities available for sale, compared to $2.4 million sold in the three months ended March 31, 2011. Also, during the three months ended March 31, 2012, $13.5 million of mortgage loans held for sale were securitized into mortgage-backed securities available for sale, compared to $3.9 million securitized in the three months ended March 31, 2011. See "Note 4. Mortgage-Backed Securities" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

Loans held for sale increased to $9.4 million at March 31, 2012, from $6.4 million at December 31, 2011. Proceeds from loan sales were $5.8 million for the three months ended March 31, 2012, compared to $6.3 million for the three months ended March 31, 2011. 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 declined to $316.3 million at March 31, 2012, from $319.4 million at December 31, 2011.

Loans and leases receivable held for investment declined to $516.4 million at March 31, 2012 from $534.0 million at December 31, 2011. During the three months ended March 31, 2012, certain loans held for investment were subjects of foreclosure and transferred to other real estate owned, as discussed below. In addition, a portion of the proceeds from principal repayments on loans held for investment is used to fund the liquidity needs of the Bank, including those discussed above.

Total loans on non-accrual status and restructured loans (TDRs) on non-accrual status declined to $37.5 million at March 31, 2012, from $43.0 million at December 31, 2011. Loans on non-accrual status declined to $11.0 million at March 31, 2012, from $21.6 million at December 31, 2011. At March 31, 2012, $2.3 million of these loans were earning interest, compared to $10.6 million at December 31, 2011. TDRs on non-accrual status increased to $26.5 million at March 31, 2012, from $21.4 million at December 31, 2011. At March 31, 2012, $20.5 million of TDRs on non-accrual status were making payments according to the terms of their restructure, compared to $12.2 million at December 31, 2011. Past due TDRs on non-accrual status declined to $6.0 million at March 31, 2012, from $9.2 million at December 31, 2011.

Performing TDRs on full accrual status declined to $9.1 million at March 31, 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 nonaccrual, over 90 days past due, classified, or restructured, there were no loans at March 31, 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 $120,000 of loans that were accruing interest and contractually over 90 days past due at March 31, 2012. Additional gross interest income of $2,000 was recorded on these loans in the three months ended March 31, 2012.

Loans are generally placed on nonaccrual 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 $74.9 million of loans classified as impaired at March 31, 2012, net of $13.2 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 March 31, 2012 and December 31, 2011, the allowance for loan and leases losses included $1.7 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 $17.3 million at March 31, 2012, from $17.0 million at December 31, 2011, reflecting the net of additions, disposals and fair value adjustments. During the three months ended March 31, 2012 there were $2.2 million of additions, $1.0 million of disposals, and $903,000 of fair value adjustments. Other real estate owned consists of residential and commercial properties, developed lots and three residential subdivisions containing 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 increased to $648.3 million at March 31, 2012, from $642.6 million at December 31, 2011. Demand accounts (personal and business checking accounts and money market accounts) increased to $262.5 million at March 31, 2012, from $243.7 million at December 31, 2011.

Time deposits declined to $354.8 million at March 31, 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 three months ended March 31, 2012 and was able to reprice new and maturing time deposits at lower rates. See "Interest Expense" below for additional information regarding the Bank's cost of funds.

Borrowed money consisting primarily of repurchase agreements declined to $1.7 million at March 31, 2012, from $2.1 million at December 31, 2011. Repurchase agreements represent funds held in cash management accounts for commercial banking customers. There were no FHLB advances outstanding at March 31, 2012 or December 31, 2011. The Bank may also use lower costing FHLB borrowings as a funding source, providing an effective means of managing its overall cost of funds.

Stockholders' equity increased to $84.3 million at March 31, 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 11.2% at March 31, 2012, compared to 11.3% at December 31, 2011. See "Consolidated Statements of Changes in Stockholders' Equity" for additional information.

Accumulated other comprehensive income was $3.4 million at March 31, 2012, compared to $3.7 million at December 31, 2011, reflecting the net unrealized gains in the available for sale mortgage-backed securities portfolio based on current market prices. See "Note 3. Comprehensive Income" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

The Bank is subject to various capital requirements administered by federal and state banking agencies. As of March 31, 2012, the Bank's regulatory capital ratios were in excess of all regulatory requirements and are listed as follows:
Total Risk-Based Capital - 15.8%; Tier 1 Risk-Based Capital - 14.5%; and Tier 1 Leverage Capital - 10.2%. See "Part 1. Financial Information - Selected Financial Data (Unaudited)" above, and "Liquidity and Capital Resources" below for additional information.

There were 1,502,951 treasury shares held totaling $32.0 million at both March 31, 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.

Comparison of Operating Results - Three months ended March 31, 2012 and 2011. Net income for the three months ended March 31, 2012 increased to $462,000, compared to $327,000 for the three months ended March 31, 2011. Net income per diluted common share increased to $0.05 per share for the three months ended March 31, 2012, from $0.03 per share for the three months ended March 31, 2011.

Net earnings during the three months ended March 31, 2012 were influenced by the amount of provisions for credit losses required to replenish net charge-offs; 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 funding expense and gains on mortgage-backed 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 value along with 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 should enhance future earnings as the current economic conditions substantially improve.

Key performance ratios are return on average assets (ROA), return on average equity (ROE), and efficiency. ROA was .3% for the three months ended March 31, 2012, compared to .2% for the three months ended March 31, 2011. ROE was 2.2% for the three months ended March 31, 2012, compared to 1.6% for the three months ended March 31, 2011. The efficiency ratio was 76.6% for the three months ended March 31, 2012, compared to 69.3% for the three months ended March 31, 2011.

Interest Income. Interest income declined to $8.9 million for the three months ended March 31, 2012, from $9.9 million for the three months ended March 31, 2011. The reduction in the amount of interest income is primarily due 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 $678.0 million for the three months ended March 31, 2012, from $708.0 million for the three months ended March 31, 2011. The reduction in average interest-earning assets reflects the net impact of the decrease in loans and leases receivable; sales, purchases and maturities of mortgage-backed securities; and the volume of other real estate owned and non-performing loans. The yield on average interest-earning assets declined to 5.3% for the three months ended March 31, 2012, from 5.6% for the three months ended March 31, 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 $1.4 million for the three months ended March 31, 2012, from $2.1 million for the three months ended March 31, 2011, reflecting lower interest rates between the comparative reporting periods and a decline in the volume of average interest-bearing liabilities. The cost of funds improved to .9% for the three months ended March 31, 2012, from 1.2% for the three months ended March 31, 2011. The Company was able to improve its cost of funds by a combination of the growth in lower costing demand accounts, new time deposit pricing and the repricing of maturing time deposits within the lower interest rate environment. Average deposits and borrowings declined to $652.3 million for the three months ended March 31, 2012, from $708.1 million for the three months ended March 31, 2011.

Net Interest Income. Net interest income declined to $7.5 million for the three months ended March 31, 2012, from $7.8 million for the three months ended March 31, 2011. The interest rate spread (the difference between the effective yield on average earning assets and the effective cost of average deposits and borrowings) remained constant at 4.4% for both the three months ended March 31, 2012 and 2011. The net yield on interest-earning assets (net interest income divided by average interest-earning assets) also remained constant at 4.4% for both the three months ended March 31, 2012 and 2011. The consistency of the interest rate spread and net yield on interest-earning assets is a result of the interest rate environment and volumes of interest-earning assets and interest-bearing liabilities 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 months ended March 31, 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 represents 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.

Yield/Cost Analysis                      Quarter Ended March 31, 2012                 Quarter Ended March 31,  2011
                                                                   (Dollars in thousands)
                                                                   Average                                       Average
                                     Average                        Yield/        Average                         Yield/
                                     Balance         Interest        Cost         Balance          Interest        Cost
Interest earning assets:
Loans receivable                   $   515,700      $    7,667         5.95 %   $    575,876      $    8,824         6.13 %
Investments and deposits               162,343           1,247         3.07 %        132,106           1,067         3.23 %
Total earning assets                   678,043           8,914         5.26 %        707,982           9,891         5.59 %
Nonearning assets                       66,352                                        86,633
Total assets                       $   744,395                                  $    794,615

Interest bearing liabilities:
Deposits                           $   543,210           1,322         0.97 %   $    593,348           1,977         1.33 %
Borrowings                               1,759               1         0.23 %          4,396              27         2.46 %
Junior subordinated debentures          10,310              92         3.57 %         10,310              81         3.14 %
Total interest-bearing
liabilities                            555,279           1,415         1.02 %        608,054           2,085         1.37 %
Noninterest bearing demand
deposits                                97,027               0         0.00 %        100,043               0         0.00 %
Total sources of funds                 652,306           1,415         0.87 %        708,097           2,085         1.18 %
Other liabilities and
stockholders' equity:
Other liabilities                        7,507                                         6,540
Stockholders' equity                    84,582                                        79,978
Total liabilities and
stockholders' equity               $   744,395                                  $    794,615
Net interest income                                 $    7,499                                    $    7,806
Interest rate spread                                                   4.29 %                                        4.41 %
Net yield on earning assets                                            4.42 %                                        4.41 %
Ratio of earning assets to
interest bearing liabilities                                         122.11 %                                      116.43 %

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 $1.8 million of provisions for credit losses in the three months ended March 31, 2012, compared to $2.5 million in the three months ended March 31, 2011. The provision for credit losses was necessary to replenish net charge offs of $2.6 million recorded in the three months ended March 31, 2012, compared to $2.0 million in the three months ended March 31, 2011, and 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 a variety of modeling, calculation methods and estimation tools for measuring credit risk and performing impairment analysis, which is the basis used in developing the allowance for credit losses. The factors supporting the allowance do not diminish the fact that the entire allowance for credit losses is available to absorb probable losses in both the loan and leases portfolio and in unfunded loan commitments. The Bank's principal focus is on the adequacy of the total allowance for credit losses. Based on the overall credit quality of the loan and lease receivable portfolio, management believes the Bank has established the allowance for credit losses pursuant to generally accepted accounting principles, and has taken into account the views of its regulators and the current economic environment. Management reassesses the information upon which it bases the allowance for credit losses not greater than quarterly and believes their accounting decisions remain accurate. However, there can be no assurance in the future that regulators, increased risks in the loan and lease portfolio, changes in economic conditions and other factors will not require additional adjustments to the allowance for credit losses.

The allowance for credit losses was $14.6 million at March 31, 2012, compared to $15.4 million December 31, 2011. The ratio of the allowance for credit losses to loans and leases was 2.8% at March 31, 2012, compared to 2.9% at December 31, 2011. See "Note 6. Allowance for Credit Losses" of "Notes to Consolidated Financial Statements (Unaudited)"and "Critical Accounting Policies - Loan Impairment and Allowance for Credit Losses" below for additional information.

Noninterest Income. Total noninterest income increased to $3.2 million for the three months ended March 31, 2012, from $2.0 million for the three months ended March 31, 2011. Noninterest income consists of fees, service charges and servicing fees earned on loans, service charges and insufficient funds fees collected on deposit accounts, gains from loan and securities sales and other miscellaneous income.

The Bank strives to maintain a consistent level of revenue across both loan and deposit service offerings. Fees, service charges and loan servicing fees collected remained constant at $1.7 million for both the three months ended March 31, 2012 and 2011. Fees, service charges and loan servicing fees are influenced by the volume of loans receivable and deposits outstanding, the volume of 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 from sales of mortgage loans held for sale increased to $305,000 for the three months ended March 31, 2012, compared to $120,000 for the three months ended March 31, 2011. The Bank sells certain held for sale fixed-rate residential mortgage loans to reduce its exposure to future interest rate and credit risk, 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 mortgage-backed securities available for sale increased to $1.0 million for the three months ended March 31, 2012, from $52,000 for the three months ended March 31, 2011. Proceeds from mortgage-backed securities sales also provide additional liquidity to support the Bank's operating, financing and lending activities.

In its efforts of mitigating nonperforming assets, the Bank recognized $29,000 of net losses on sales of other real estate owned properties in the three months ended March 31, 2012, compared to $82,000 of net losses recognized in the three months ended March 31, 2011. See "Note 8. Other Real Estate Owned" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

Noninterest Expense. Total noninterest expenses increased to $8.2 million for the three months ended March 31, 2012, from $6.8 million for the three months ended March 31, 2011. Compensation and fringe benefits, the largest component of these expenses, increased to $4.2 million for the three months ended March 31, 2012, from $3.8 million for the three months ended March 31, 2011, reflecting an increase in retirement benefits and management's efforts to maintain sufficient staffing levels necessary to support commercial and retail customer service activities, credit administration and banking operations.

FDIC insurance premiums declined to $252,000 for the three months ended March 31, 2012, from $292,000 for the three months ended March 31, 2011, reflecting the volume of insured deposit account balances during the respective periods, 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 versus on deposits.

Expenses attributable to valuation adjustments, renovating, maintenance and property taxes paid for the current volume of other real estate owned properties increased to $1.3 million for the three months ended March 31, 2012, from $220,000 for the three months ended March 31, 2011. See "Note 8. Other Real Estate Owned" and "Note 9. Fair Value Measurement" of "Notes to Consolidated Financial Statements (Unaudited)" for additional information.

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

Income Taxes. Income tax expense was $201,000 for the three months ended March 31, 2012, compared $225,000 for the three months ended March 31, 2011. Changes in the amount of income tax expense reflects changes in pretax income, deductible expenses, the application of permanent and temporary differences and the applicable income tax rates in effect during each period. The effective income tax rates were 30.3% for the three months ended March 31, 2012, compared to 40.7% for the three months ended March 31, 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 funding needs. Adequate liquidity guarantees that sufficient funds are available to meet . . .