Unassociated Document

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PART I. — Financial Information

Item 1. Condensed Consolidated Financial Statements:

Condensed Consolidated Statements of Financial Condition September 30, 2008 and December 31, 2007	1

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2008 and 2007	2

Condensed Consolidated Statements of Comprehensive Income for the Nine Months Ended September 30, 2008 and 2007	3

Condensed Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2008 and 2007	4

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007	5

Notes to Condensed Consolidated Financial Statements	6

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	9

Item 3. Quantitative and Qualitative Disclosures About Market Risk	20

Item 4. Controls and Procedures	20

PART II — Other Information	21

Item 1. Legal Proceedings	21

Item 1A. Risk Factors	21

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	21

Item 3. Defaults Upon Senior Securities	22

Item 4. Submission of Matters to a Vote of Security Holders	22

Item 5. Other Information	22

Item 6. Exhibits	22

Signatures	22

	September 30,			December 31,
	2008			2007
	(unaudited)
Assets:
Cash and cash equivalents	$	13,924		$	29,739
Investment securities available-for-sale, at fair value		26,512			46,519
Mortgage-backed and related securities available-for-sale, at fair value		81,010			69,893
Loans:
Loans receivable, net of unearned income		628,496			559,956
Allowance for loan losses		(7,027	)		(6,144	)
Net loans		621,469			553,812
Other real estate owned		1,214			529
Premises and equipment, net		17,334			17,965
Accrued interest receivable		2,621			3,254
Federal Home Loan Bank stock		5,355			4,236
Intangible assets		30,635			31,037
Cash value of bank-owned life insurance policies		16,635			16,099
Other assets		6,321			6,057
Total assets	$	823,030		$	779,140

Liabilities and Stockholders’ Equity:
Deposits:
Demand deposit accounts	$	114,318		$	101,981
Money market deposit accounts		107,555			129,688
Savings accounts		11,288			12,037
Time deposits		351,767			347,059
Total deposits		584,928			590,765
Borrowed money		147,518			96,284
Deferred compensation		5,407			5,389
Other liabilities		2,350			2,669
Total liabilities		740,203			695,107

Stockholders’ Equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized, none issued		-			-
Common stock, $0.01 par value, 20,000,000 shares authorized; Issued: 9,062,727 shares;

Outstanding: 7,516,816 shares at September 30, 2008 and 7,610,017 shares at December 31, 2007		91			91
Additional paid-in-capital		67,289			67,718
Unallocated common stock held by Employee Stock Ownership Plan		(1,110	)		(1,247	)
Retained earnings		36,332			36,028
Accumulated other comprehensive loss, net of deferred income taxes		(1,442	)		(343	)
Treasury stock of 1,545,911 shares at September 30, 2008, and 1,452,710 shares at December 31, 2007, at cost		(18,333	)		(18,214	)
Total stockholders’ equity		82,827			84,033
Total liabilities and stockholders’ equity	$	823,030		$	779,140

	Three Months					Nine Months
	Ended September 30,					Ended September 30,
	2008			2007		2008			2007
Interest Income:
Loans	$	9,416		$	10,377	$	28,160		$	30,331
Investment securities		358			710		1,127			2,070
Interest-bearing deposits		13			73		149			342
Mortgage-backed and related securities		1,019			783		2,825			2,150
Total interest income		10,806			11,943		32,261			34,893

Interest Expense:
Deposits		3,997			5,741		13,397			16,672
Borrowed funds		1,427			1,099		3,783			2,999
Total interest expense		5,424			6,840		17,180			19,671

Net interest income		5,382			5,103		15,081			15,222
Provision for loan losses		720			300		1,815			960
Net interest income after provision for loan losses		4,662			4,803		13,266			14,262

Noninterest Income:
Fee income on deposit accounts		802			680		2,256			2,026
Mortgage banking income		169			239		650			749
Income on lending activities		84			116		297			358
Dividends on FHLB stock		40			53		168			149
Increase in cash value of bank-owned life insurance		195			191		571			578
Fair value adjustment on deferred compensation assets		(12	)		52		(65	)		110
Life insurance proceeds, net		-			-		-			112
Net gain on sale of assets		14			-		275			336
Other noninterest income		200			203		613			633
Total noninterest income		1,492			1,534		4,765			5,051

Noninterest Expense:
Compensation and benefits		2,565			2,461		7,665			7,167
Fair value adjustment on deferred comp. obligations		(12	)		52		(65	)		110
Occupancy and equipment expense		662			661		2,013			2,001
Professional services		201			127		639			403
Amortization of intangible assets		126			156		402			483
Reorganization expenses		-			-		220			-
Impairment of securities		468			-		468			162
Other noninterest expense		1,135			1,097		3,388			3,130
Total noninterest expense		5,145			4,554		14,730			13,456

Income before income taxes		1,009			1,783		3,301			5,857

Provision for income taxes		187			434		647			1,519

Net income	$	822		$	1,349	$	2,654		$	4,338

Net income per common share:
Basic	$	0.11		$	0.18	$	0.36		$	0.56
Diluted	$	0.11		$	0.18	$	0.36		$	0.55

Weighted average common shares outstanding:
Basic		7,358,086			7,627,620		7,380,236			7,748,605
Diluted		7,386,513			7,691,722		7,414,274			7,817,438

	Nine Months
	Ended September 30,
	2008			2007

Net income	$	2,654		$	4,338

Items of other comprehensive income:
Items of other comprehensive income, before tax
Unrealized holding gains arising during period		(1,504	)		(88	)
Reclassification adj. for securities (gains) losses included in net income		(284	)		79
Other comprehensive loss, before tax		(1,788	)		(9	)
Change in deferred income taxes related to changes in unrealized gains or losses on securities available for sale		689			4
Items of other comprehensive loss, net of tax		(1,099	)		(5	)

Comprehensive income	$	1,555		$	4,333

	Nine Months
	Ended September 30,
	2008			2007

Common stock, $0.01 par value:
At beginning of period	$	91		$	91
Issuance of common stock		-			-
At end of period		91			91

Additional paid-in-capital:
At beginning of period		67,718			67,439
Grant of additional shares from Recognition and Retention Plan (“RRP”)		(720	)		(128	)
Vesting of shares for RRP		248			226
Stock-based compensation expense		43			23
At end of period		67,289			67,560

Unallocated common stock held by ESOP:
At beginning of period		(1,247	)		(1,430	)
Allocation from shares purchased with loan from ESOP		137			137
At end of period		(1,110	)		(1,293	)

Retained earnings, substantially restricted:
At beginning of period		36,028			33,031
Net income		2,654			4,338
Accrual of post retirement benefits		(350	)		-
Exercise of options		(126	)		(199	)
Dividends paid		(1,875	)		(1,855	)
At end of period		36,332			35,315

Accumulated unrealized loss on securities available for sale, net of tax:
At beginning of period		(343	)		(991	)
Other comprehensive income, net of tax		(1,099	)		(5	)
At end of period		(1,442	)		(996	)

Treasury stock:
At beginning of period		(18,214	)		(12,179	)
Exercise of options		180			283
Grant of additional shares from RRP		720			128
Purchase of common stock for treasury		(1,019	)		(4,531	)
At end of period		(18,333	)		(16,299	)

	Nine Months
	Ended September 30,
	2008			2007

Cash flows from operating activities:
Net income	$	2,654		$	4,338
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,815			960
Depreciation		836			886
Impairment on investment securities		468			162
Net gain on sale of investment securities		(125	)		(1	)
Net (gain) loss on sale of mortgage-backed securities		(159	)		80
Net gain on sale of loans		-			(5	)
Net loss on sale of other real estate owned		16			9
Net gain on sale of premises and equipment		(7	)		(419	)
Deferred loan origination fees (costs)		73			(69	)
Allocation of shares to the ESOP		137			137
Stock-based compensation expense		43			23
Vesting of shares for the Recognition and Retention Plan		248			226
Increase (decrease) in accrued interest receivable		634			(476	)
Amortization of intangible assets		402			483
(Increase) decrease in other assets		(1,106	)		1,567
Decrease in other liabilities		(480	)		(358	)
Net cash provided by operating activities		5,449			7,543

Cash flows from investing activities:
Net increase in loans		(69,545	)		(33,184	)
Proceeds from the sale of investment securities		19,323			3,000
Proceeds from the sale of mortgage-backed securities		12,485			3,364
Proceeds from the sale of loans		-			202
Proceeds from sale of other real estate owned		295			233
Proceeds from sale of premises and equipment		15			801
Maturities and prepayments of investment securities		2,341			9,987
Maturities and prepayments of mortgage-backed securities		11,398			9,608
Purchases of investments		(3,659	)		(9,805	)
Purchases of mortgage-backed securities		(34,970	)		(18,208	)
Purchases of FHLB stock		(1,120	)		(205	)
Capital expenditures for premises and equipment		(213	)		(1,153	)
Net cash used in investment activities		(63,650	)		(35,360	)

Cash flows from financing activities:
Net increase (decrease) in deposits		(5,837	)		9,312
Exercise of options		54			84
Post retirement benefit accrual		(350	)		-
Dividends paid		(1,875	)		(1,855	)
Purchase of common stock for treasury		(1,019	)		(4,531	)
Net increase in borrowed money		51,234			10,018
Increase in advances from borrowers for insurance and taxes		179			228
Net cash provided by financing activities		42,386			13,256

Net decrease in cash and cash equivalents		(15,815	)		(14,561	)
Cash and cash equivalents at beginning of period		29,739			26,221

Cash and cash equivalents at end of period	$	13,924		$	11,660

The condensed consolidated financial statements of Citizens South Banking Corporation (the “Company”) are unaudited and reflect all adjustments of a normal recurring nature which are, in the opinion of management, necessary for a fair presentation of the interim period financial statements as of and for the three- and nine-month periods ended September 30, 2008 and 2007. Amounts as of December 31, 2007, included in the condensed consolidated financial statements and related notes were derived from the audited consolidated financial statements. Results for the three- and nine-month periods ended September 30, 2008, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2008.

The unaudited condensed consolidated financial statements of the Company have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission, including Rule 10-01 of Regulation S-X. Accordingly, certain information normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share is calculated by dividing net income by the sum of the weighted average number of common shares outstanding and potential common stock. Potential common stock consists of additional common stock that would have been outstanding as a result of the exercise of dilutive stock options. In determining the number of shares of potential common stock, the treasury stock method was applied. This method assumes that the number of shares issuable upon exercise of the stock options is reduced by the number of common shares assumed purchased at market prices with the proceeds from the assumed exercise of the common stock options plus any tax benefits received as a result of the assumed exercise. The following is a summary of the diluted earnings per share calculation for the three and nine months ended September 30, 2008 and 2007:

Commitments to extend credit are agreements to lend as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These commitments represent no more than normal lending risk that the Bank commits to its borrowers and management believes that these commitments can be funded through normal operations. Commitments to extend credit that include both fixed and variable rates are as follows:

On June 16, 2008, the Board of Directors of the Company authorized the repurchase of up to 200,000 shares, or approximately 2.7% of the Company’s then outstanding shares of common stock. These repurchases may be carried out through open market purchases, block trades, and negotiated private transactions. The stock may be repurchased on an ongoing basis and will be subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial performance. Under this plan the Company had repurchased a total of 9,476 shares at an average price of $7.91 per share and had 190,524 shares remaining to be repurchased at September 30, 2008. The Company will consider repurchasing additional shares of common stock of the Company at prices management considers to be attractive and in the best interests of both the Company and its stockholders. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”), which provides a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. This Statement defines fair value as the exchange price that would be received for an asset or paid to transfer a liability in the most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. The Company has not elected the fair value option for liabilities. Available-for-sale securities are recorded at fair value on a recurring basis. Additionally, the Company may be required to record at fair value other assets on a nonrecurring basis. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting for these other assets. At September 30, 2008, the Company did not have any loans held for sale.

Investment securities available-for-sale are recorded at fair value on at least a monthly basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 fair value is used for those securities traded on an active exchange and U.S. Treasury securities that are traded by broker/dealers in an active over-the-counter market and money market funds. As of September 30, 2008, the Company did not have any securities that were valued using Level 1. Securities valued using Level 2 include mortgage-backed securities issued by government-sponsored enterprises ($81.0 million), municipal bonds ($23.0 million), and bonds issued by government agencies ($495,000). Securities valued using Level 3 include equity securities that are not actively traded on an active exchange ($848,000), investments in closely held subsidiaries ($464,000) and asset-backed securities traded in less liquid markets ($1.7 million). The fair value measurement as of September 30, 2008, for investment securities available-for-sale is summarized below:

This report contains certain forward-looking statements that represent the Company's expectations or beliefs concerning future events. Such forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. These forward-looking statements are based on assumptions with respect to future business strategies and decisions that are subject to change based on changes in the economic and competitive environment in which we operate. Forward-looking statements speak only as of the date they are made and the Company is under no duty to update these forward-looking statements or to reflect the occurrence of unanticipated events. A number of factors could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements. Factors that could cause such a difference include, but are not limited to, the timing and amount of revenues that may be recognized by the Company, changes in local or national economic trends, increased competition among depository and financial institutions, continuation of current revenue and expense trends (including trends affecting chargeoffs and provisions for loan losses), changes in interest rates, changes in the shape of the yield curve, and adverse legal, regulatory or accounting changes. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on these statements. Readers should carefully review the risk factors described in other documents the Company files from time to time with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K.

	Three Months Ended September 30, 2008			Three Months Ended September 30, 2007			% Change			Nine Months Ended September 30, 2008			Nine Months Ended September 30, 2007			% Change
Earnings:
Net interest income	$	5,382		$	5,103			5.47	%	$	15,081		$	15,222			(0.93)	%
Provision for loan losses		(720	)		(300	)		140.00			(1,815	)		(960	)		89.06
Noninterest income		1,492			1,534			(2.74	)		4,765			5,051			(5.66	)
Noninterest expense		(5,145	)		(4,554	)		12.98			(14,730	)		(13,456	)		9.47
Income tax expense		(187	)		(434	)		(56.91	)		(647	)		(1,519	)		(57.41	)
Net Income	$	822		$	1,349			(39.07	)	$	2,654		$	4,338			(38.82	)

Per Share Data:
Avg. common shares outstanding, basic		7,358,086			7,627,620			(3.53)	%		7,380,236			7,748,605			(4.75)	%
Basic net income	$	0.11		$	0.18			(38.89	)	$	0.36		$	0.56			(35.71	)

Avg. common shares outstanding, diluted		7,386,513			7,691,722			(3.97)	%		7,414,274			7,817,438			(5.16)	%
Diluted net income	$	0.11		$	0.18			(38.89	)	$	0.36		$	0.55			(34.55	)

Cash dividends paid	$	0.085		$	0.08			6.25	%	$	0.255		$	0.24			6.25	%
Period-end book value		11.02			10.86			1.47			11.02			10.86			1.47

Financial Ratios (annualized):
Return on average stockholders’ equity		3.97	%		6.37	%		(37.68)	%		4.25	%		6.83	%		(37.77)	%
Return on average assets		0.40			0.70			(42.86	)		0.45			0.78			(42.31	)
Efficiency ratio		74.85			68.61			9.09			74.22			66.37			11.83
Net interest margin		3.02			3.13			(3.51	)		2.96			3.19			(7.21	)
Average equity to average assets		10.09			11.09			(9.02	)		10.54			11.37			(7.30	)

Asset Quality Data:
Allowance for loan losses	$	7,027		$	6,292			11.68	%	$	7,027		$	6,292			11.68	%
Nonperforming loans		3,335			2,528			31.92			3,335			2,528			31.92
Nonperforming assets		4,549			3,164			43.77			4,549			3,164			43.77
Net charge-offs		450			136			230.88			932			433			115.24
Allowance for loan losses to total loans		1.12	%		1.15	%		(2.61	)		1.12	%		1.15	%		(2.61	)
Nonperforming loans to total loans		0.53			0.46			15.22			0.53			0.46			15.22
Nonperforming assets to total assets		0.55			0.42			30.95			0.55			0.42			30.95

Average Balances:
Total assets	$	817,613		$	759,132			7.70	%	$	794,066		$	746,974			6.30	%
Loans, net of unearned income		615,755			541,396			13.73			590,554			528,800			11.68
Interest-earning assets		724,949			668,671			8.42			700,225			653,662			7.12
Deposits		581,162			579,141			0.35			579,810			573,373			1.12
Interest-bearing liabilities		685,823			625,128			9.71			659,411			612,301			7.69
Stockholders’ equity		82,478			83,984			(1.79	)		83,685			84,912			(1.45	)

At Period End:
Total assets	$	823,030		$	760,987			8.15	%	$	823,030		$	760,987			8.15	%
Loans, net of unearned income		621,469			548,026			13.40			621,469			548,026			13.40
Interest-earning assets		732,683			666,874			8.25			732,683			676,874			8.25
Deposits		584,928			572,114			2.24			584,928			572,114			2.24
Interest-bearing liabilities		691,600			628,084			10.11			691,600			628,084			10.11
Stockholders’ equity		82,827			84,378			(1.84	)		82,827			84,378			(1.84	)

The accounting and reporting policies of the Company and its subsidiaries are based on accounting principles generally accepted in the United States and conform to general practices in the banking industry. We consider a critical accounting policy to be one that is both very important to the portrayal of the Company’s financial condition and results of operations and requires a difficult, subjective or complex judgment by management. What makes these judgments difficult, subjective and/or complex is the need to make estimates about the effects of matters that are inherently uncertain. Changes in underlying factors, assumptions or estimates could have a material impact on our future financial condition and results of operations. Based on the size of the item or significance of the estimate, our critical accounting and reporting policies include our accounting for the allowance for loan losses and evaluation of other-than-temporary impairment of investments.

Management has established a systematic method for periodically evaluating the credit quality of the loan portfolio in order to establish an allowance for loan losses. The methodology is set forth in a formal policy and includes a review of all loans in the portfolio on which full collectibility may or may not be reasonably assured. The loan review considers among other matters, the estimated fair value of the collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Specific allowances are established for certain individual loans that management considers impaired under SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower, the term of the loan, general economic conditions, and in the case of a secured loan, the quality of the collateral. We increase our allowance for loan losses by charging provisions for loan losses against our current period income. Management’s periodic evaluation of the adequacy of the allowance is consistently applied and is based on our past loan loss experience, particular risks inherent in the different kinds of lending that we engage in, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, current economic conditions, and other relevant internal and external factors that affect loan collectibility. Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

Other-Than-Temporary Impairment of Securities. Management periodically reviews all investment securities with significant declines in fair value for potential other-than-temporary impairment pursuant to the guidance provided by SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. In November 2006, the FASB issued Staff Position (“FSP”) FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The FSP addressed the determination as to when an investment is considered impaired, whether the impairment is other-than-temporary, and the measurement of an impairment loss. It also included accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amended SFAS No. 115“Accounting for Certain Investments in Debt and Equity Securities”, No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations”, and APB Opinion 18, “The Equity Method of Accounting for Investments in Common Stock”.

Effective September 30, 2008, management evaluated the Company’s investment portfolio and determined that the $468,000 impairment on a $1.0 million trust preferred collateralized debt obligation was other-than-temporary. This investment is collateralized by trust preferred securities that were issued by a pool of 40 banks operating throughout the country. Management determined that the impairment was other-than-temporary because 1) two of the original 40 banks had defaulted on their payments; 2) the security, which had an original credit rating of “A-”, was on negative watch and subject to downgrade by one or more of the credit rating agencies; and 3) the interest rate of LIBOR plus 105 basis points on this security was well below the current pricing for bank capital which approximated LIBOR plus 400 basis points at September 30, 2008. Management determined that it was unlikely that the pricing for bank capital would return to a level consistent with the pricing on the Company’s security in the foreseeable future. Due to the lack of liquidity for this type of security in the current environment, the security was valued using Level 3. The fair value was prepared by an independent third party using a discounted cash flow model using various default assumptions ranging from 10% to 40%. The fair value of $532,000 was determined based on a weighted average of the various default assumptions, with the 20% default rate as the most likely scenario over the life of the security. The current default rate on this security is 5.25%.

Assets. Total assets of the Company increased by $43.9 million, or 5.6%, from $779.1 million at December 31, 2007, to $823.0 million at September 30, 2008. This increase was primarily due to a $68.5 million, or 12.2%, increase in loans receivable to $628.5 million at September 30, 2008. The growth in loans was primarily comprised of a $27.7 million, or 33.7%, increase in consumer loans to $109.7 million, a $34.6 million, or 12.6%, increase in commercial real estate loans to $308.3 million, a $1.0 million, or 3.0%, increase in commercial business loans to $34.2 million, and a $7.0 million, or 9.0%, increase in residential loans to $85.0 million. These increases in loans were partly offset by a $2.8 million, or 3.2%, decrease in residential and commercial construction loans to $86.5 million. Loan production remained strong during the first nine months of 2008, totaling $216.1 million, compared to $234.7 million during the first nine months of 2007. The economy in the Charlotte region remains relatively stable compared to other regions of the country; however, housing starts and demand for commercial real estate have slowed during 2008. As a result, management expects that loan growth will slow during the remainder of 2008. Management will seek to continue to grow the loan portfolio in a prudent manner with an emphasis on borrowers that have a demonstrated capacity to meet their debt obligations, even as the local economy slows.

As of September 30, 2008, $268.2 million, or 43.1%, of the Company’s loan portfolio, was scheduled to reprice in one month. This sensitivity to falling short-term interest rates was a factor in the Company’s margin compression during the first half of 2008 as the prime rate decreased by 275 basis points during the period. However, during the third quarter of 2008, there were no decreases in short-term interest rates and a large number of time deposits repriced at lower rates, resulting in a decreased cost of funds. As a result, the Company’s net interest margin improved by 11 basis points from 2.91% for the second quarter of 2008 to 3.02% for the third quarter of 2008. However, the recent 50 basis point decrease in short-term interest rates in the fourth quarter of 2008 by the Federal Reserve will likely result in margin compression for the fourth quarter of 2008.

Cash and cash equivalents decreased by $15.8 million, or 53.2%, from $29.7 million at December 31, 2007, to $13.9 million at September 30, 2008. This decrease was primarily attributable to loan growth of $68.5 million, an $11.1 million increase in mortgage-backed securities (“MBS”) and decreases in deposits of $5.8 million. These outlays of cash were partly offset by a $20.0 million decrease in investment securities and a $51.2 million increase in borrowed money. Management expects that the level of cash and cash equivalents will remain relatively stable through the remainder of 2008. Proceeds needed to fund future loan growth are expected to be generated from growth in deposits, maturing investments and MBS and / or additional borrowings.

During the nine-month period ended September 30, 2008, investment securities decreased by $20.0 million, or 43.0%, to $26.5 million. The decrease in investment securities was primarily due to normal maturities of $2.3 million and the sale of $19.3 million of investment securities during the period. These decreases in investment securities were partly offset by the purchase of $3.7 million of investment securities during the period. MBS increased $11.1 million, or 15.9%, to $81.0 million. The increase in MBS was due to the purchase of $35.0 million of MBS during the period, the effects of which were partly offset by the sale of $12.5 million in MBS and by $11.4 million of normal principal amortization. The investment securities and MBS were primarily sold to fund loan growth. Management expects the investment and MBS portfolios to decrease as a percentage of total assets as the cash flows generated from these investments and MBS are used to fund loan growth or repay borrowings. This rebalancing of the balance sheet from lower-yielding cash and cash equivalents, investments, and MBS to higher-yielding loans is expected to be a positive factor in improving the Company’s net interest margin.

Allowance for loan losses and nonperforming assets. The Company has established a systematic methodology for determining the adequacy of the allowance for loan losses as previously discussed. The allowance for loan losses is increased by charging provisions for loan losses against income. As of September 30, 2008, the allowance for loan losses was $7.0 million, or 1.12% of total loans. Management believes that this amount meets the requirement for losses on loans that management considers to be impaired, for known losses, and for losses inherent in the remaining loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations. The following table presents an analysis of changes in the allowance for loan losses for the comparable periods and information with respect to nonperforming assets at the dates indicated.

	At and For the Three						At and For the Nine
	Months Ended September 30,						Months Ended September 30,
	2008			2007			2008			2007
	(dollars in thousands)						(dollars in thousands)
Allowance for loan losses:
Beginning of period	$	6,757		$	6,128		$	6,144		$	5,764
Add:
Provision for loan losses		720			300			1,815			960
Recoveries		3			66			52			86
Less:
Charge-offs		453			202			984			519
End of period	$	7,027		$	6,292		$	7,027		$	6,292

Nonaccrual loans	$	3,335		$	2,528		$	3,335		$	2,528
Real estate owned		1,214			636			1,214			636
Nonperforming assets	$	4,549		$	3,164		$	4,549		$	3,164

Allowance for loan losses as a percentage of total loans		1.12	%		1.15	%		1.12	%		1.15	%

Nonperforming loans to total loans		0.53	%		0.46	%		0.53	%		0.46	%

Nonperforming assets to total assets		0.55	%		0.42	%		0.55	%		0.42	%

Premises and equipment decreased by $631,000, or 3.5%, to $17.3 million at September 30, 2008. During 2008, the Company opened a full-service office located in a leased facility in Rock Hill, South Carolina. Also during 2008, the Company closed its mortgage loan production office and consolidated the operations of its two commercial loan production offices into existing branch facilities. As a result, there were no loan production offices operating as of September 30, 2008. This consolidation of loan production offices was a cost cutting measure that was done as a part of the Company’s reorganization efforts during the first quarter of 2008. No significant changes to the Company’s premises and equipment are anticipated for the remainder of 2008.

While total deposits decreased by $5.8 million, or 1.0%, to $584.9 million at September 30, 2008, demand deposit accounts (checking accounts) increased by $12.3 million, or 12.1%, to $114.3 million at September 30, 2008. The increase in demand deposit accounts was primarily due to a continued emphasis on increasing the Company’s number of retail and business customers through employee incentive plans and enhanced treasury service products. Also, time deposits increased by $4.7 million, or 1.4%, to $351.8 million at September 30, 2008. The increase in demand deposit accounts and time deposits was offset by a $22.1 million, or 17.1%, decrease in money market deposit accounts to $107.6 million and a $749,000, or 6.2%, decrease in savings accounts to $11.3 million at the end of the reporting period. The decrease in these interest-sensitive money market deposit accounts was largely due to the Company’s action to aggressively lower its deposit rates more quickly than some of its competitors in response to the Federal Reserve Board’s actions to lower the federal funds rate by 225 basis points during the nine-month period ended September 30, 2008. The Company will continue to actively market the Company’s deposit products at pricing points that management believes to be profitable. Management has always focused on increasing deposits by building customer relationships and typically avoids growing deposits by offering the highest rates in the market. The Company opened its 15^th full-service office in Rock Hill, South Carolina during the first quarter of 2008. This additional office, the Company’s first in South Carolina, will be an integral part of the Company’s efforts to continue growing core deposits and market share in the Charlotte region. However, if loan growth continues to significantly outpace deposit growth, management may be more aggressive in pricing retail deposits, which may increase the Company’s cost of funds. In addition, management may use brokered deposits to fund future loan growth if additional liquidity is needed. Brokered deposits totaled $12.4 million, or 2.1% of total deposits, at September 30, 2008, compared to $3.6 million, or 0.6%, of total deposits at December 31, 2007.

Stockholders’ Equity. Total stockholders’ equity decreased by $1.2 million, or 1.4%, from $84.0 million at December 31, 2007, to $82.8 million at September 30, 2008. The decrease in stockholders’ equity was partly due to a $1.1 million increase in unrealized losses on available-for-sale investment securities and MBS. This increase in unrealized losses was primarily due to increases in long-term interest rates and higher spreads resulting from increased volatility in the securities markets. With the exception of the $468,000 other-than-temporary impairment that was discussed earlier in the “Critical Accounting Policies” section of this report, management expects that these losses are temporary in nature and that the market value of the securities portfolio will recover in the foreseeable future.

Also, during the nine-month period the Company repurchased 102,828 shares of common stock at an average cost of $9.91 per share, resulting in a $1.0 million decrease in stockholders’ equity. On October 22, 2007, the Board of Directors authorized the repurchase of up to 200,000 shares, or approximately 2.5%, of the then outstanding shares of common stock. This repurchase plan was completed in June 2008. An additional repurchase plan was authorized by the Board of Directors on June 16, 2008. The new plan authorized the repurchase of 200,000 shares, or approximately 2.7% of the Company’s then outstanding shares of common stock. These repurchases may be carried out through open market purchases, block trades, and negotiated private transactions. The stock may be repurchased on an ongoing basis and will be subject to the availability of stock, general market conditions, the trading price of the stock, alternative sources and uses for capital, and the Company’s financial performance. Under the current plan the Company had repurchased a total of 9,476 shares at an average price of $7.91 per share and had 190,524 shares remaining to be repurchased at September 30, 2008. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

General. Net income for the three months ended September 30, 2008, amounted to $822,000, or $0.11 per diluted share, as compared to $1.3 million, or $0.18 per diluted share, for the three months ended September 30, 2007. This represented a 39.1% decrease in net income and a 38.9% decrease in diluted earnings per share for the comparable periods. This decrease was largely due to an additional $420,000 in the provision for loan losses resulting from a $314,000 increase in net loan losses during the third quarter of 2008 and a $468,000 other-than-temporary impairment on a $1.0 million trust preferred collateralized debt obligation that was charged against earnings during the third quarter of 2008.

Net interest income. Interest income decreased by $1.1 million, or 9.5%, to $10.8 million for the third quarter of 2008, primarily as a result of a lower market rates due to a 275 basis point decrease in short-term interest rates from September 30, 2007 to September 30, 2008. As of September 30, 2008, approximately 43% of the Company’s loan portfolio was scheduled to reprice on a monthly basis. Average interest-earning assets increased by $56.3 million, or 8.4%, to $724.9 million for the three months ended September 30, 2008. The increase in average interest-earning assets was primarily the result of a $74.4 million, or 13.7%, increase in average outstanding loans to $615.8 million for the quarter ended September 30, 2008. The increase in average loans was partly offset by an $18.3 million, or 15.2%, decrease in average investments and MBS. The Company’s average yield on earning assets decreased by 119 basis points to 5.99% for the quarter ended September 30, 2008, as a result of lower interest rates during the comparable periods. Interest expense decreased by $1.4 million, or 20.7%, for the comparable quarters to $5.4 million for the third quarter of 2008. This decrease in interest expense was largely due to lower market interest rates. As a result, the average cost of funds decreased by 121 basis points to 3.13% for the quarter ended September 30, 2008. The benefits of lower market rates were partly offset by a $60.7 million, or 9.7%, increase in the average balance of interest-bearing liabilities to $685.8 million for the three months ended September 30, 2008. Average interest-bearing liabilities increased primarily as a result of a $59.9 million, or 70.4%, increase in average borrowed money coupled with a $750,000, or 0.14%, increase in average interest-bearing deposits.

As a result of the decrease in interest rates during the comparable periods, the tax-equivalent net interest margin decreased by 11 basis points to 3.02% for the quarter ended September 30, 2008, compared to 3.13% for the quarter ended September 30, 2007. This decrease in the tax-equivalent net interest margin was primarily the result of yields on earning assets falling at a faster rate than the cost of funds. On a linked-quarter basis, the Company’s tax-equivalent net interest margin increased 11 basis points from 2.91% for the second quarter of 2008 to 3.02% for the third quarter of 2008. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, a decrease in short-term interest rates would have a more pronounced negative impact in the first three months following the decrease. The short-term negative effects of a decrease in interest rates are expected to be mostly offset by time deposits that mature over the next 12 months and reprice at a lower cost to the Company.

Provision for loan losses. The provision for loan losses amounted to $720,000 for the third quarter of 2008 compared to $300,000 for the third quarter of 2007, representing a $420,000 increase. The primary reason for the increase was $314,000 in additional write-offs that were realized during the third quarter of 2008 as compared to the third quarter of 2007. The increase in write-offs was primarily due to the slowing local housing market. As a result of these write-offs, the Company increased the amount of the provision for loan losses in order to maintain an adequate level of allowance for loan losses. The allowance for loan losses was $7.0 million, or 1.12% of total loans as of September 30, 2008, compared to $6.3 million, or 1.15% of total loans as of September 30, 2007. Credit quality continued to compare favorably with industry peers with a ratio of nonperforming loans to total loans of 0.53% on September 30, 2008, compared to 0.46% on September 30, 2007. A substantial portion of the Company’s nonperforming loans at September 30, 2008, was secured by real estate located in the Company’s primary lending market. In addition, the Company’s ratio of nonperforming assets to total assets was 0.55% at September 30, 2008, compared to 0.42% at September 30, 2007. Net chargeoffs totaled $450,000, or 0.07% of average loans, during the third quarter of 2008 compared to $136,000, or 0.02% of average loans, during the third quarter of 2007.

Noninterest income. Noninterest income decreased by $42,000, or 2.7%, to $1.5 million for the three months ended September 30, 2008. The change in noninterest income was largely attributable to decreases in fee income on mortgage banking activities, fee income on lending activities, dividends on FHLB stock, other noninterest income, and fair value adjustments on deferred compensation assets. The slowdown in the local housing market was primarily responsible for a decrease in mortgage lending activity and residential construction loan closings. As a result, fee income on mortgage banking activities and lending activities was down by $70,000 and $32,000, respectively, from the third quarter of 2007 to the third quarter of 2008. Reductions in short-term interest rate reductions by the Federal Reserve over the past 12 months contributed to a $13,000 reduction in dividends received on FHLB stock. Other noninterest income was down $3,000 in part due to lower commissions on the sale of uninsured deposit products. The $64,000 decrease in the fair value of deferred compensation assets was directly offset by a decrease in noninterest expense, resulting in no net impact on the earnings of the Company.

These decreases in noninterest income were partly offset by a $122,000 increase in fee income on deposit accounts, a $4,000 increase in the cash value of bank-owned life insurance, and a $14,000 net gain on the sale of assets. An increase in the number of demand deposit customers contributed to the improvement in deposit fee income. The Company remains focused on increasing the number of demand deposit accounts in the future. The $14,000 increase in the net gain on sale of assets resulted from a $1,000 net gain on the sale of $5.8 million in investment securities, a $6,000 net gain on the sale of $112,000 in real estate owned, and a $7,000 net gain on the sale of $15,000 in miscellaneous fixed assets.

Other increases in noninterest expense included a $104,000, or 4.2%, increase in compensation and benefits, a $1,000, or 0.2%, increase in occupancy and equipment expense, a $74,000, or 58.3%, increase in professional services, and a $38,000, or a 3.5%, increase in other noninterest expenses. Management hired several experienced lenders and an experienced credit officer during 2007 which contributed to the increase in compensation and benefits. However, we expect that the additional loan growth associated with these new positions will generate revenue to offset the additional compensation expense in 2008. The Company also opened its 15th full-service office in Rock Hill, South Carolina, during the first quarter 2008, which resulted in an increase in office occupancy and equipment expense. However, this increase has been tempered by the consolidation of the Company’s three loan production offices into existing branch facilities. The increase in professional services was primarily associated with higher audit-related costs, consulting fees and legal services. Management expects that these expenses will decrease for the remainder of 2008. Other noninterest expenses increased as a result of higher expenses related to data processing and technology, deposit operations, and loan collection and administration. A portion of the increase was related to the opening of the new office during the first quarter of 2008.

Income taxes. Income taxes amounted to $187,000, or 18.5% of taxable income, for the quarter ended September 30, 2008, as compared to $434,000, or 24.3% of taxable income, for the quarter ended September 30, 2007. The decrease in the effective tax rate during the comparable periods was primarily due to a $774,000 decrease in income before income taxes. In addition, tax equivalent adjustments increased from 34.7% of net income for the quarter ended September 30, 2007, to 47.9% of net income for the quarter ended September 30, 2008. This nontaxable income was primarily generated from interest earned on bank-qualified municipal securities and loans. The Company invests in tax-advantaged sources of income to reduce its overall tax burden. However, as the Company continues to increase the amount of income derived from interest income on loans and fee income on loans and deposits, the effective tax rate is expected to increase.

General. Net income for the nine months ended September 30, 2008, amounted to $2.7 million, or $0.36 per diluted share, as compared to $4.3 million, or $0.55 per diluted share, for the nine months ended September 30, 2007. This represented a 38.8% decrease in net income and a 34.6% decrease in diluted earnings per share for the comparable periods. This decrease was largely due to an additional $855,000 in the provision for loan losses resulting from a $499,000 increase in net loan losses during the third quarter of 2008 and a $468,000 other-than-temporary impairment on a $1.0 million trust preferred collateralized debt obligation that was charged against earnings during the third quarter of 2008.

Net interest income. Interest income decreased by $2.6 million, or 7.5%, to $32.3 million for the nine months ended September 30, 2008, primarily as a result of lower short-term interest rates. As of September 30, 2008, approximately 43% of the Company’s loan portfolio was scheduled to reprice on a monthly basis. Average interest-earning assets increased by $46.6 million, or 7.1%, to $700.2 million for the nine months ended September 30, 2008. The increase in average interest-earning assets was primarily the result of a $61.8 million, or 11.7%, increase in average outstanding loans to $590.6 million. This increase was partly offset by a $16.3 million, or 11.9%, decrease in average investments and MBS during the comparable periods. Due to decreases in short-term interest rates over the past 12 months, the Company’s average yield on earning assets decreased by 100 basis points to 6.22% for the nine months ended September 30, 2008. Interest expense decreased by $2.5 million, or 12.7%, for the comparable periods to $17.2 million for the nine months ended September 30, 2008. This decrease in interest expense was largely due to lower market interest rates. As a result, the average cost of funds decreased by 81 basis points to 3.48% for the nine months ended September 30, 2008. The benefit of lower interest rates was partly offset by a $47.1 million, or 7.7%, increase in the average balance of interest-bearing liabilities to $659.4 million for the nine months ended September 30, 2008. Average interest-bearing liabilities increased primarily as a result of a $42.0 million, or 53.7%, increase in borrowed money coupled with a $5.1 million, or 1.0%, increase in average interest-bearing deposits.

As a result of the decrease in interest rates during the comparable periods, the tax-equivalent net interest margin decreased by 23 basis points to 2.96% for the nine months ended September 30, 2008, compared to 3.19% for the nine months ended September 30, 2007. This decrease in the net interest margin was primarily the result of yields on earning assets falling at a faster rate than the cost of funds. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, decreases in short-term interest rates would have a more pronounced negative impact in the first three months. The short-term negative effects of a decrease in interest rates are expected to be mostly offset by time deposits that mature over the next 12 months and reprice at a lower cost to the Company.

Provision for loan losses. The provision for loan losses amounted to $1.8 million for the nine months ended September 30, 2008, compared to $960,000 for the nine months ended September 30, 2007, representing an $855,000 increase. The primary reason for the increase was $499,000 in additional net chargeoffs that were realized during the first nine months of 2008 as compared to the first nine months of 2007. The increase in net chargeoffs was primarily due to the slowing local housing market. As a result, the Company increased the amount of the provision for loan losses in order to maintain an adequate level of the allowance for loan losses. The allowance for loan losses was $7.0 million, or 1.12% of total loans as of September 30, 2008, compared to $6.3 million, or 1.15% of total loans as of September 30, 2007. Credit quality continues to compare favorably with industry peers with a ratio of nonperforming loans to total loans of 0.53% on September 30, 2008, compared to 0.46% on September 30, 2007. A substantial portion of the Company’s nonperforming loans at September 30, 2008, was secured by real estate located in the Company’s primary lending market. In addition, the Company’s ratio of nonperforming assets to total assets was 0.55% at September 30, 2008, compared to 0.42% at September 30, 2007. Net chargeoffs totaled $932,000, or 0.16% of average loans, during 2008 compared to $433,000, or 0.08% of average loans, during 2007.

Noninterest income. Noninterest income decreased by $286,000, or 5.7%, to $4.8 million for the nine months ended September 30, 2008, as compared to $5.0 million for the nine months ended September 30, 2007. This decrease was largely attributable to a $99,000, or 13.2%, decrease in fee income on mortgage banking activities, a $61,000, or 17.0%, decrease in fee income on lending activities, a $7,000, or 1.2%, decrease in cash value on bank-owned life insurance, a $20,000, or 3.1%, decrease in other noninterest income and a $175,000 decrease in the fair value adjustment on deferred compensation assets. The income generated from mortgage banking activities decreased due to a reduction in mortgage lending activity in the Charlotte region. However, the residential real estate market in the Charlotte region remains relatively active and is expected to provide the Company with continued opportunities for growth in the future. The decrease in fee income on lending activities was largely the result of originating fewer construction and acquisition and development loans during 2008. These loans typically generate higher fee income than other types of loans. Cash value on bank owned life insurance decreased slightly due to lower market rates during the comparable periods. The decrease in other noninterest income was primarily due to lower commissions on the sale on uninsured deposit products. The decrease in the fair value on deferred compensation assets was directly offset by a decrease in noninterest expense, resulting in no net impact on the earnings of the Company.

In addition, the Company experienced a $61,000 decrease in the net gain on sale of assets and an $112,000 decrease in net life insurance proceeds payable to the Company. The Company recognized $275,000 in net gains from the sale of assets during the nine months ended September 30, 2008, compared to $336,000 during the nine months ended September 30, 2007. During the first nine months of 2008 the Company sold $19.3 million of investment securities at a net gain of $125,000 and $12.5 million of mortgage-backed securities at a net gain of $159,000. These securities were primarily sold to generate proceeds to fund loan growth. In addition, during the nine months ended September 30, 2008, the Company sold $295,000 in other real estate owned at a loss of $16,000 and sold $15,000 of miscellaneous fixed assets at a net gain of $7,000. During the nine months ended September 30, 2007, the Company sold $801,000 in real estate including a small portion of land from an existing branch office site and a vacant building that was previously used as the operations center for the former Citizens Bank that was acquired in 2001. These sales resulted in a net gain of $419,000. Also during 2007, the Company sold $202,000 in loans at a net gain of $5,000. Offsetting a portion of these gains were losses of $80,000 from the sale of $3.4 million in mortgage-backed securities and $9,000 from the sale of various parcels of foreclosed properties. In 2007, an officer of the Company passed away, resulting in net life insurance proceeds of $112,000 that were paid to the Company.

Noninterest expense. Noninterest expense increased by $1.3 million, or 9.5%, to $14.7 million for the nine months ended September 30, 2008, compared to $13.4 million for the nine months ended September 30, 2007. This resulted from a $498,000, or 7.0%, increase in compensation and benefits, a $12,000, or 0.6%, increase in occupancy and equipment expense, a $236,000, or 58.6%, increase in professional services, and a $258,000, or 8.2%, increase in other noninterest expenses. Management hired several experienced lenders and an experienced credit officer during 2007 which contributed to the increase in compensation and benefits. However, we expect that the additional loan growth associated with these new positions will generate revenues to offset the additional compensation expense in 2008. The Company also opened its 15th full-service office in Rock Hill, South Carolina, during the first quarter 2008. As a result, office occupancy and equipment expense is expected to continue to increase in 2008. However, this increase has been tempered by the consolidation of the Company’s three loan production offices into existing branch facilities. The increase in professional services was primarily associated with higher audit-related costs, consulting fees and legal services. Management expects that these expenses will decrease for the remainder of 2008. Other noninterest expenses increased as a result of higher expenses related to data processing and technology, deposit operations, and loan collection and administration. A portion of the increase was related to the opening of a new office during the first quarter of 2008.

In addition, the Company experienced increases of $306,000 for impairment of securities and $220,000 in restructuring expense. Effective September 30, 2008, management determined that there was a $468,000 other-than-temporary impairment charge on a $1.0 million trust preferred collateralized debt obligation. This investment is discussed above in the section “Other-Than-Temporary Impairment of Securities”. Effective June 30, 2007, management evaluated the Company’s investment portfolio and determined that a $162,000 impairment existed on a $305,000 equity investment that was considered to be other-than-temporary, resulting in a $162,000 charge to earnings. The $220,000 restructuring expense was attributable to severance payments made to various employees whose positions were eliminated during the first quarter of 2008. No additional expenses are expected in conjunction with the reorganization.

Income taxes. Income taxes amounted to $647,000, or 19.6% of taxable income, for the nine months ended September 30, 2008, as compared to $1.5 million, or 25.9% of taxable income, for the nine months ended September 30, 2007. The decrease in the effective tax rate during the comparable periods was primarily due to a $2.6 million decrease in income before taxes. In addition, tax equivalent adjustments increased from 26.0% of net income for the nine-month period ended September 30, 2007, to 43.7% of net income for the nine months ended September 30, 2008. This nontaxable income was primarily generated from interest earned on bank-qualified municipal securities and loans. The Company invests in tax-advantaged sources of income to reduce its overall tax burden. However, as the Company continues to increase the amount of income derived from interest income on loans and fee income on loans and deposits, the effective tax rate is expected to increase.

The objectives of the Company’s liquidity management policy include providing adequate funds to meet the cash needs of both borrowers and depositors, to provide for the on-going operations of the Company, and to capitalize on opportunities for expansion. Liquidity management addresses the Company’s ability to meet deposit withdrawals on demand or at contractual maturity, to repay borrowings as they mature, and to fund new loans and investments as opportunities arise. The primary sources of internally generated funds are principal and interest payments on loans receivable, increases in local deposits, cash flows generated from operations, and cash flows generated by investments. If the Company requires funds beyond its internal funding capabilities, it may rely upon external sources of funds such as brokered deposits, repurchase agreements, and advances. The Company has $77.7 million available to draw from its line of credit with the FHLB. The FHLB functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB, we are required to own capital stock in the FHLB and we are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities that are obligations of, or guaranteed by, U.S. Government Agencies) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. The Company also has $11.8 million available from a $20.0 million unsecured federal funds accommodation with Silverton Bank (“Silverton”). Silverton is the Company’s primary correspondent bank. The federal funds accommodation is for a term of 12 months and is used for the purpose of providing daily liquidity as needed by the Company. Outstanding advances made under this accommodation are generally repaid on a daily basis at a rate determined by Silverton based on their marginal cost of funds. Advances are limited to not more than 14 days in any calendar month. Interest on any advances made over the established line or beyond the 14-day limit will be at a higher rate. The Company may also solicit brokered deposits for providing funds for asset growth. As of September 30, 2008, the Company had outstanding brokered deposits of $12.4 million, or 2.1% of total deposits. This balance was comprised of two time deposits in the amounts of $6.0 million and $6.4 million. Both deposits had maturities of less than six months and a weighted average cost of funds of 2.91%. The Company believes that it has sufficient sources of liquidity to fund the cash needs of both borrowers and depositors, to provide for the ongoing operations of the Company, and to capitalize on opportunities for expansion.

In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements. Commitments to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The funding of these commitments and previously approved undisbursed lines of credit could affect the Company's liquidity position. At September 30, 2008, the Company had loan commitments of $13.0 million, unused lines of credit of $111.7 million, and undisbursed construction loan proceeds of $3.6 million. The Company believes that it has adequate resources to fund loan commitments and lines of credit as they arise. The Company does not have any special purpose entities or other similar forms of off-balance-sheet financing.

The Bank is subject to various regulatory capital requirements administered by the banking regulatory agencies. As of September 30, 2008, the Bank’s capital exceeded all applicable regulatory requirements and was in the “well capitalized” category for all regulatory capital measurements. The Bank's Tier I capital was $66.8 million, or 8.4% of adjusted total assets. The minimum Tier I capital ratio is 4.00%. Failure to meet minimum capital requirements can result in certain mandatory and possibly discretionary actions by the regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.

Under the supervision and with the participation of the Company’s management, including the Company’s Principal Executive Officer and Principal Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective.

FDIC Assessment Risk Factor. The Federal Deposit Insurance Corporation (“FDIC”) imposes an assessment against financial institutions for deposit insurance. This assessment is based on the risk category of the institution and ranges from 5 to 43 basis points of the institution’s deposits. Federal law requires the FDIC to maintain a reserve ratio of 1.15% to 1.50% of estimated insured deposits. Recent bank failures have significantly reduced the deposit reserve ratio. As a result, the FDIC published a proposed rule that would restore the reserve ratio to its federally-mandated level. The proposed rule would raise the current deposit insurance assessment rates for all institutions by approximately 7 basis points beginning with the first quarter of 2009. There can be no assurance that the proposed rule will be implemented by the FDIC in its proposed form. However, the actions taken by the FDIC could significantly increase the Company’s noninterest expense in 2009 and in future years as long as the increased premiums are in place.

As of September 30, 2008, the Company had repurchased a total of 3,209,211 shares, or 35.4% of the original outstanding shares of common stock, at an average price of $13.06. This stock was repurchased under a series of repurchase programs that have been authorized by the Board of Directors over the past several years. The most recent repurchase authorization was granted by the Board of Directors on June 16, 2008, for the repurchase of up to 200,000 shares, or approximately 2.7% of the Company’s then outstanding shares of common stock. These repurchases may be carried out through open market purchases, block trades, and negotiated private transactions. The stock may be repurchased on an ongoing basis and will be subject to the availability of stock, general market conditions, the trading price of the stock, alternative uses for capital, and the Company’s financial condition and/or performance. As of September 30, 2008, the Company had repurchased a total of 4,776 shares at an average price of $7.86 per share and had 195,224 shares remaining to be repurchased under this plan. Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

Delaware		54-2069979
(State or other jurisdiction of		(I.R.S. Employer Identification Number)
incorporation or organization)

519 South New Hope Road, Gastonia, NC		28054
(Address of principal executive offices)		(Zip Code)

	September 30, 2008		December 31, 2007
Loan commitments:
Residential mortgage loans	$	6,350,490	$	7,160,455
Non-residential mortgage loans		3,174,600		20,987,431
Commercial loans		1,165,000		6,559,700
Consumer loans		2,282,000		6,840,137
Total loan commitments	$	12,972,090	$	41,547,723
Unused lines of credit:
Commercial	$	33,791,244	$	38,120,483
Consumer		77,890,622		71,831,349
Total unused lines of credit	$	111,681,866	$	109,951,832

	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Total
	(in thousands)

Securities available for sale	$	-	$	104,478	$	3,044	$	107,522

Period	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan		Maximum Number of Shares that May Yet be Purchased Under the Publicly Announced Plan
July		7,200	$	7.95		9,476		190,524
August		-		-		9,476		190,524
September		-		-		9,476		190,524
Total		7,200	$	7.95		9,476		190,524

þ	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
	For the quarterly period ended September 30, 2008

o	Transitional report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
	For the transition period from ______ to _____

	Three Months				Nine Months
	Ended September 30,				Ended September 30,
	2008		2007		2008		2007
	(dollars in thousands, except per share amounts)

Net income	$	822	$	1,349	$	2,654	$	4,338

Weighted average shares outstanding		7,358,086		7,627,620		7,380,236		7,748,605
Dilutive effect of stock options		28,427		64,102		34,038		68,833
Weighted average diluted shares outstanding		7,386,513		7,691,722		7,414,274		7,817,438

Diluted earnings per share	$	0.11	$	0.18	$	0.36	$	0.55

	Citizens South Banking Corporation


Date: November 10, 2008	By:	/s/ Kim S. Price
		Kim S. Price
		President and Chief Executive Officer


Date: November 10, 2008	By:	/s/ Gary F. Hoskins
		Gary F. Hoskins
		Executive Vice President, Chief Financial Officer and Treasurer