10-Q 1 v157571_10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2009

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

For the transition period from ______ to _____

Commission File Number 0-23971

Citizens South Banking Corporation

(Exact name of registrant as specified in its charter)

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

519 South New Hope Road, Gastonia, NC 28054

(Address of principal executive offices)

(704) 868-5200

(Registrant's telephone number, including area code)

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

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports). Yes ¨ No ¨

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

Large accelerated filer ¨	Accelerated filer ¨

Non-accelerated filer ¨	Smaller Reporting Company x

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

As of August 13, 2009, there were 7,526,854 shares outstanding shares of the Registrant’s common stock, $0.01 par value.

Citizens South Banking Corporation

Form 10-Q for the Quarterly Period Ended June 30, 2009

Table of Contents

Index

	Page
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements:

Condensed Consolidated Statements of Financial Condition as of June 30, 2009 (unaudited) and December 31, 2008	1

Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2009 and 2008 (unaudited)	2

Condensed Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2009 and 2008 (unaudited)	3

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2009 and 2008 (unaudited)	4

Notes to Condensed Consolidated Financial Statements	5

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	13

Item 3. Quantitative and Qualitative Disclosures About Market Risk	26

Item 4. Controls and Procedures	26

PART II. OTHER INFORMATION

Item 1. Legal Proceedings	26

Item 1A. Risk Factors	26

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	27

Item 3. Defaults Upon Senior Securities	27

Item 4. Submission of Matters to a Vote of Security Holders	28

Item 5. Other Information	28

Item 6. Exhibits	28

Signatures	29

Certifications

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

Citizens South Banking Corporation

Condensed Consolidated Statements of Financial Condition

(Dollars in thousands, except share and per share data)

	June 30,			December 31,
	2009			2008
	(unaudited)
Assets:
Cash and cash equivalents:
Cash and due from banks	$	8,353		$	9,444
Interest-earning bank balances		31,120			613
Total cash and cash equivalents		39,473			10,057
Investment securities available-for-sale, at fair value		92,378			109,180
Investment securities, held-to-maturity, at amortized cost		5,074			-
Loans:
Loans receivable, net of unearned income and deferred fees		629,962			626,688
Allowance for loan losses		(8,685	)		(8,026	)
Loans receivable, net		621,277			618,662
Other real estate owned		2,111			2,601
Premises and equipment, net		16,383			16,834
Accrued interest receivable		2,515			2,609
Federal Home Loan Bank common stock, at cost		4,149			4,793
Bank-owned life insurance		17,158			16,813
Intangible assets		30,363			30,525
Other assets		5,402			5,139
Total assets	$	836,283		$	817,213

Liabilities and Stockholders’ Equity:
Deposits:
Demand deposit accounts	$	149,466		$	122,731
Money market deposit accounts		110,770			103,271
Savings accounts		11,156			10,708
Time deposits		344,841			344,778
Total deposits		616,233			581,488
Borrowed money		110,221			124,365
Deferred compensation		4,935			5,413
Other liabilities		736			1,227
Total liabilities		732,125			712,493

Stockholders’ Equity:
Preferred stock, $0.01 par value, 10,000,000 shares authorized; 20,500 shares issued and outstanding at June 30, 2009 and December 31, 2008		20,548			20,507
Common stock, $0.01 par value, 20,000,000 shares authorized; 9,062,727 shares issued at June 30, 2009 and December 31, 2008, 7,526,854 shares outstanding at June 30, 2009 and 7,515,957 shares outstanding at December 31, 2008		91			91
Additional paid-in-capital		67,590			67,366
Unallocated common stock held by Employee Stock Ownership Plan		(973	)		(1,064	)
Retained earnings		35,350			36,088
Accumulated other comprehensive income		(175	)		25
Treasury stock of 1,535,873 shares at June 30, 2009 and 1,546,770 shares at December 31, 2008		(18,273	)		(18,293	)
Total stockholders’ equity		104,158			104,720
Total liabilities and stockholders’ equity	$	836,283		$	817,213

See accompanying notes to condensed consolidated financial statements.

Citizens South Banking Corporation

Condensed Consolidated Statements of Operations (unaudited)

(Dollars in thousands, except share and per share data)

	Three Months					Six Months
	Ended June 30,					Ended June 30,
	2009			2008		2009			2008
Interest Income:
Loans	$	8,441		$	9,143	$	16,799		$	18,745
Investment securities		381			356		754			769
Interest-bearing deposits		13			42		18			136
Mortgage-backed and related securities		843			942		1,793			1,805
Total interest income		9,678			10,483		19,364			21,455

Interest Expense:
Deposits		3,196			4,334		6,724			9,400
Borrowed funds		1,150			1,237		2,324			2,356
Total interest expense		4,346			5,571		9,048			11,756

Net interest income		5,332			4,912		10,316			9,699
Provision for loan losses		1,950			750		2,850			1,095
Net interest income after provision for loan losses		3,382			4,162		7,466			8,604

Noninterest Income:
Service charges on deposit accounts		822			776		1,569			1,454
Mortgage banking income		462			278		760			481
Other loan fees		80			102		138			213
Dividends on FHLB stock		-			65		-			128
Income from bank-owned life insurance		182			188		368			376
Net gain on sale of assets		235			19		64			261
Other noninterest income		235			164		366			360
Total noninterest income		2,016			1,592		3,265			3,273

Noninterest Expense:
Compensation and benefits		2,526			2,506		5,018			5,047
Occupancy and equipment expense		652			676		1,326			1,351
Professional fees		237			237		474			438
Amortization of intangible assets		81			135		162			276
FDIC deposit insurance		491			17		593			34
Valuation adjustment on other real estate owned		50			-		175			-
Restructuring expenses		-			-		-			220
Impairment of securities		91			-		214			-
Other noninterest expense		1,111			1,131		2,214			2,219
Total noninterest expense		5,239			4,702		10,176			9,585

Net income before income taxes		159			1,052		555			2,292
Income tax expense (benefit)		(155	)		190		(216	)		460
Net income		314			862		771			1,832
Dividends on preferred stock		259			-		513			-

Net income available for common stockholders	$	55		$	862	$	258		$	1,832

Net income per common share:
Basic	$	0.01		$	0.12	$	0.03		$	0.25
Diluted	$	0.01		$	0.12	$	0.03		$	0.25
Weighted average common shares outstanding:
Basic		7,403,359			7,369,964		7,398,079			7,391,338
Diluted		7,403,359			7,434,006		7,398,079			7,443,803

See accompanying notes to condensed consolidated financial statements.

Citizens South Banking Corporation

Condensed Consolidated Statements of Changes in Stockholders’ Equity (unaudited)

(Dollars in thousands, except per share data)

	Six Months
	Ended June 30,
	2009			2008

Preferred stock, $0.01 par value:
At beginning of period	$	20,507		$	-
Accumulated discount on preferred stock		41			-
At end of period		20,548			-

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		67,366			67,718
Vesting of shares for Recognition and Retention Plan		171			154
Stock-based compensation expense		53			15
At end of period		67,590			67,887

Unallocated common stock held by ESOP:
At beginning of period		(1,064	)		(1,247	)
Allocation from shares purchased with loan from ESOP		91			91
At end of period		(973	)		(1,156	)

Retained earnings, substantially restricted:
At beginning of period		36,088			36,028
Net income		258			1,832
Accumulated discount on preferred stock		(41	)		-
Stock options exercised		(20	)		(126	)
Dividends paid		(935	)		(1,240	)
At end of period		35,350			36,494

Accumulated unrealized loss on securities available for sale, net of tax:
At beginning of period		25			(343	)
Other comprehensive income		(200	)		(1,494	)
At end of period		(175	)		(1,837	)

Treasury stock:
At beginning of period		(18,293	)		(18,214	)
Stock options exercised		20			181
Repurchase of common stock		-			(951	)
At end of period		(18,273	)		(18,984	)

See accompanying notes to condensed consolidated financial statements.

Citizens South Banking Corporation

Condensed Consolidated Statements of Cash Flows (unaudited)

(Dollars in thousands)

	Six Months
	Ended June 30,
	2009			2008
Cash flows from operating activities:
Net income	$	258		$	1,832
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		2,850			1,095
Depreciation		537			554
Impairment on equity investment		214			-
Net gain on sale of investment securities		(308	)		(283	)
Net loss on sale of other real estate owned		244			22
Writedown on other real estate owned		175			-
Deferred loan origination fees		7			44
Allocation of shares to the ESOP		91			91
Stock based compensation		53			15
Vesting of shares for the Recognition and Retention Plan		171			154
Increase in accrued interest receivable		94			516
Amortization of intangible assets		162			276
Increase in other assets		(1,964	)		(441	)
Decrease in other liabilities		(1,233	)		(1,085	)
Net cash provided by operating activities		1,351			2,790

Cash flows from investing activities:
Net increase in loans		(5,473	)		(45,425	)
Proceeds from the sale of investment securities		21,566			25,887
Proceeds from the sale of premises and equipment		6			-
Proceeds from the sale of other real estate owned		1,552			183
Maturities and prepayments of investment securities - AFS		11,523			9,394
Maturities and prepayments of investment securities - HTM		11			-
Purchases of investment securities - AFS		(16,518	)		(38,629	)
Purchases of investment securities - HTM		(5,085	)		-
(Purchases) sale of FHLB stock		644			(1,102	)
Capital expenditures for premises and equipment		(92	)		(194	)
Net cash provided by (used in) investment activities		8,134			(49,886	)

Cash flows from financing activities:
Net increase (decrease) in deposits		34,746			(5,964	)
Net increase (decrease) in borrowed money		(14,144	)		40,994
Dividends paid		(935	)		(1,240	)
Issuance of common stock for options		-			55
Repurchase of common stock		-			(951	)
Increase in advances from borrowers for insurance and taxes		264			277
Net cash provided by financing activities		19,931			33,171

Net increase (decrease) in cash and cash equivalents		29,416			(13,925	)
Cash and cash equivalents at beginning of period		10,057			29,739

Cash and cash equivalents at end of period	$	39,473		$	15,814


Supplemental non-cash investing activity:
Reclassification of loans to other real estate owned	$	1,688		$	324

See accompanying notes to condensed consolidated financial statements.

CITIZENS SOUTH BANKING CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of Citizens South Banking Corporation (the “Company”) and its wholly-owned subsidiary, Citizens South Bank (the “Bank”). The following unaudited condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate. It is suggested that these condensed financial statements be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K for December 31, 2008.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The more significant estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. Actual results could differ from those estimates.

In the opinion of management, all adjustments necessary for a fair presentation of the interim financial statements as of and for the six-month periods ended June 30, 2009 and 2008 have been included as required by Regulation S-X Rule 10-01. All significant intercompany transactions have been eliminated in consolidation. Certain amounts reported in prior periods have been reclassified to conform to the current presentation. Such reclassifications had no effect on total assets, net income, or stockholders equity as previously reported. Results for the six-month period ended June 30, 2009, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2009.

The condensed consolidated balance sheet at December 31, 2008, was derived from the audited consolidated financial statements presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

Note 2 - Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of financial information by the Company.

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an Amendment of FASB Statement No. 133.” SFAS No. 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial condition, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. SFAS No. 161 did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued Staff Position (“FSP”) SFAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP SFAS 157-4”). This FSP emphasizes that even if there has been a significant decrease in the volume and level of activity, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants. The FSP provides a number of factors to consider when evaluating whether there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity. In addition, when transactions or quoted prices are not considered orderly, adjustments to those prices based on the weight of available information may be needed to determine the appropriate fair value. The FSP also requires increased disclosures. This FSP is effective for interim and annual reporting periods ending after June 15, 2009, and shall be applied prospectively. Early adoption is permitted for periods ending after March 15, 2009. The adoption of this FSP at June 30, 2009 did not have a material impact on the results of operations or financial condition.

In April 2009, the FASB issued FSP SFAS 115-2 and SFAS 124-2, “Recognition and Presentation of Other-than-temporary impairments.” FSP SFAS 115-2 and SFAS 124-2 are intended to provide greater clarity to investors about the credit and noncredit component of an other-than-temporary impairment event and to communicate more effectively when an other-than-temporary impairment event has occurred. FSP SFAS 115-2 and SFAS 124-2 amend the other-than-temporary impairment guidance in GAAP for debt securities. The new guidance improves the presentation and disclosure of other-than-temporary impairment on investment securities and changes the calculation of the other-than-temporary impairment recognized in earnings in the financial statements. These Statements do not amend existing recognition and measurement guidance related to other-than-temporary impairment of equity securities.

For debt securities, FSP SFAS 115-2 and SFAS 124-2 require an entity to assess whether (a) it has the intent to sell the debt security, or (b) it is more likely than not that it will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, an other-than-temporary impairment on the security must be recognized.

In instances in which a determination is made that a credit loss (defined by FSP SFAS 115-2 and SFAS 124-2 as the difference between the present value of the cash flows expected to be collected and the amortized cost basis) exists but the entity does not intend to sell the debt security and it is not more likely than not that the entity will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis (i.e., the amortized cost basis less any current-period credit loss), FSP SFAS 115-2 and SFAS 124-2 change the presentation and amount of the other-than-temporary impairment recognized in the income statement.

In these instances, the impairment is separated into (a) the amount of the total impairment related to the credit loss, and (b) the amount of the total impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total impairment related to all other factors is recognized in other comprehensive loss and will be amortized over the remaining life of the debt security as an increase in the carrying value of the security (with no effect on earnings unless the security is subsequently sold or there is additional other-than-temporary impairment losses recognized). The total other-than-temporary impairment is presented in the income statement with an offset for the amount of the total other-than-temporary impairment that is recognized in other comprehensive loss. Previously, in all cases, if an impairment was determined to be other-than-temporary, an impairment loss was recognized in earnings in an amount equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date of the reporting period for which the assessment was made. The new presentation provides additional information about the amounts that the entity does not expect to collect related to a debt security.

FSP SFAS 115-2 and SFAS 124-2 are effective and are to be applied prospectively for financial statements issued for interim and annual reporting periods ending after June 15, 2009. When adopting FSP SFAS 115-2 and SFAS 124-2, an entity is required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-than-temporary impairment from retained earnings to accumulated other comprehensive loss if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before the anticipated recovery of its amortized cost basis. The adoption of these FSPs did not have a material impact on the Company’s consolidated financial statements.

In April 2009, the FASB issued FSP SFAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP SFAS 107-1 and APB 28-1”). FSP SFAS 107-1 and APB 28-1 amend the disclosure requirements in SFAS No. 107, “ Disclosures about Fair Value of Financial Instruments ” (“SFAS 107”), and APB Opinion No. 28, “Interim Financial Reporting,” to require disclosures about the fair value of financial instruments within the scope of SFAS 107, including disclosure of the method(s) and significant assumptions used to estimate the fair value of financial instruments, in interim financial statements as well as in annual financial statements. Previously, these disclosures were required only in annual financial statements. FSP SFAS 107-1 and APB 28-1 are effective and should be applied prospectively for financial statements issued for interim and annual reporting periods ending after June 15, 2009. In periods after initial adoption, FSP SFAS 107-1 and APB 28-1 require comparative disclosures only for periods ending subsequent to initial adoption and do not require earlier periods to be disclosed for comparative purposes at initial adoption. The Company adopted FSP SFAS 107-1 and APB 28-1 on April 1, 2009. The adoption of FSP SFAS 107-1 and APB 28-1 resulted in increased financial statement disclosures.

In May 2009, the FASB issued SFAS No. 165, “Subsequent Events,” which establishes general standards of and accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issues or are available to be issued. SFAS No. 165 was effective for interim and annual periods ending after June 15, 2009. The Company has complied with the requirements of SFAS No. 165.

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162.” Under SFAS No 168, The FASB Accounting Standards Codification (“Codification”) will become the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. In the FASB’s view, the issuance of this Statement and the Codification will not change GAAP, except for those nonpublic nongovernmental entities that must now apply the American Institute of Certified Public Accountants Technical Inquiry Service Section 5100, “Revenue Recognition,” paragraphs 38–76. The Company does not expect that the adoption of this Statement will have a material impact on the Company’s consolidated financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial statements.

Note 3 – Fair Value Measurements

On January 1, 2008, the Company adopted 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. An orderly transaction is a transaction that assumes exposure to the market for a sufficient period prior to the measurement date to allow for marketing activities that are usual and customary for such transactions. Market participants are buyers and sellers in the principal market that are independent, knowledgeable, and willing and able to transact. SFAS No. 157 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets (observable inputs) and the lowest priority to the Company’s assumptions (unobservable inputs). SFAS No. 157 requires fair value measurements to be separately disclosed by level within the fair value hierarchy. For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in SFAS No. 157.

Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon estimates, are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.

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. Investment securities, available-for-sale, 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, such as impaired loans and other real estate owned. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting for these other assets. The application of SFAS No. 157 in situations where the market for a financial asset is not active was clarified by the issuance of SFAS No. 157-4 as outlined in Note 2.

In accordance with SFAS No. 157, when measuring fair value, the Company uses valuation techniques that are appropriate and consistently applied. A fair value hierarchy is used based on the markets in which the assets are traded and the reliability of the assumptions used to determine the fair value. These levels are as follows:

Level 1: Valuations are based on quoted prices in active markets for identical instruments.

Level 2: Valuations that are derived from readily available pricing sources for market transactions involving similar types of instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3: Valuations are derived from other valuation methodologies, including option pricing models, discounted cash flow models, and similar techniques and not based on market exchange or broker traded transactions.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value. The determination of where an instrument falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter and based on various factors, it is possible that an instrument may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be limited.

Investment Securities, Available-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, U.S. Treasury securities that are traded by brokers or dealers in an active over-the-counter market, and money market funds. Level 2 securities include mortgage-backed securities issued by government-sponsored enterprises, municipal bonds, and corporate debt securities. Securities valued using Level 3 include equity securities that are not traded on an active exchange, investments in closely held subsidiaries, and asset-backed securities traded in less liquid markets.

Loans - The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as being impaired, management measures the impairment in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The fair value of impaired loans is estimated using one of several methods, including collateral value, market price and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At June 30, 2009, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS No. 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

Other Real Estate Owned - Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current certified appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis:

	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
June 30, 2009
Investment securities, available-for-sale	$	-	$	90,963	$	1,415	$	92,378

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis:

	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
June 30, 2009
Impaired loans	$	-	$	5,534	$	11,063	$	16,597
Other real estate owned			$	2,111	$	-	$	2,111

Note 4 – Computation of Earnings per Share

The Company is required to report both basic and diluted earnings per share (“EPS”). Basic EPS is calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS is calculated by dividing net income available to common stockholders by the sum of the weighted average number of common shares outstanding for the period 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. The treasury 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.

For the six-month periods ended June 30, 2009 and 2008, options to purchase 796,967 shares and 662,290 shares, respectively, were excluded from the calculation of diluted earnings per share because the option price exceeded the average closing price of the associated shares of common stock during the respective periods.

The following is a summary of the diluted earnings per share calculation for the three and six months ended June 30, 2009 and 2008:

	Three Months Ended June 30,				Six Months Ended June 30,
	2009		2008		2009		2008
	(dollars in thousands, except per share amounts)

Net income available to common stockholders	$	55	$	862	$	258	$	1,832

Shares used in the computation of EPS:
Weighted avg. number of shares outstanding		7,403,359		7,369,964		7,398,079		7,391,338
Incremental shares from assumed exercise of stock options		-		64,042		-		52,465
Weighted average number of shares outstanding - diluted		7,403,359		7,434,006		7,398,079		7,443,803

Diluted EPS	$	0.01	$	0.12	$	0.03	$	0.25

Note 5 – Comprehensive Income

The Company follows SFAS No. 130, Reporting Comprehensive Income, which establishes standards for reporting and displaying comprehensive income and its components (revenues, expenses, gains, and losses) in general-purpose financial statements. Comprehensive income is the change in the Company’s equity during the period from transactions and other events and circumstances from non-owner sources. Total comprehensive income consists of net income and other comprehensive income. The Company’s other comprehensive income and accumulated other comprehensive income are comprised of unrealized gains and losses on certain investments. Information concerning the Company’s other comprehensive income for the six month periods ended June 30, 2009 and 2008 is as follows:

	Six Months
	Ended June 30,
	2009			2008
	(Dollars in thousands)

Net income available to common stockholders	$	258		$	1,832

Other comprehensive income:
Items of other comprehensive income, before tax
Unrealized gains arising during period		633			2,713
Reclassification for realized losses included in net income		(308	)		(283	)
Other comprehensive income, before tax		325			2,430
Tax benefit		(125	)		(936	)
Other comprehensive income		200			1,494

Total comprehensive income	$	458		$	3,326

Note 6 – Commitments to Extend Credit

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:

	June 30, 2009		December 31, 2008
	(Dollars in thousands)
Loan commitments:
Residential mortgage loans	$	10,183	$	5,904
Non-residential mortgage loans		14,557		5,934
Commercial loans		407		457
Consumer loans		1,984		3,242
Total loan commitments	$	27,131	$	15,537
Unused lines of credit:
Commercial	$	17,979	$	26,424
Consumer		77,640		78,872
Total unused lines of credit	$	95,619	$	105,296

Note 7 – Dividend Declaration

On July 20, 2009, the Board of Directors of the Company approved and declared a regular cash dividend of four cents ($0.04) per share of common stock to stockholders of record as of August 1, 2009, payable on August 15, 2009. The Company has paid cash dividends in each of the 45 quarters since the Company’s conversion to public ownership.

Note 8 – Stock Repurchase Program

In June 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. As of June 30, 2009, 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 under the plan. On December 12, 2008, the Company entered into a Letter Agreement with the United States Department of the Treasury ("U.S. Treasury") pursuant to which the Company has issued and sold to the U.S. Treasury: (i) 20,500 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share, having a liquidation amount per share equal to $1,000, for a total price of $20,500,000 and (ii) a warrant to purchase 428,870 shares of the Company's common stock, par value $0.01 per share, at an exercise price per share of $7.17. As a condition for issuing the preferred stock under the U.S. Treasury Capital Purchase Program (“CPP”), the U.S. Treasury limited the Company’s ability to repurchase common stock of the Company and increase its dividend payments to stockholders without receiving prior approval from the U.S. Treasury. As a result, future repurchases of Company common stock are not anticipated for 2009.

Note 9 - Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. The estimates are significantly affected by the assumptions used, including discount rates and estimates of future cash flows. These estimates may differ substantially from amounts that could be realized in an immediate sale or settlement of the instrument.

Fair value approximates book value for the following financial instruments due to their short-term nature: cash and due from banks, interest-earning bank balances, and advances from customers for taxes and insurance.

Fair value for investment securities and mortgage-backed and related securities are based on quoted market prices. If a quoted market price is not available, fair value is estimated using market prices for similar securities.

Fair value for variable rate loans that reprice frequently is based on the carrying value reduced by an estimate of credit losses inherent in the portfolio. Fair value for all other loans is estimated by discounting their future cash flows using interest rates currently being offered for loans of comparable terms and credit quality.

Fair value for demand deposit accounts and interest-bearing accounts with no fixed maturity is equal to the carrying value. Certificate of deposit fair values are estimated by discounting cash flows from expected maturities using interest rates currently being offered for similar instruments.

Fair value for repurchase agreements and other borrowed money is based on discounted cash flows using current interest rates.

At June 30, 2009, and December 31, 2008, the Company had outstanding unfunded commitments to extend credit offered in the normal course of business. Fair values of these commitments are based on fees currently charged for similar instruments. At June 30, 2009, and December 31, 2008, the carrying amounts and fair values of these off-balance sheet financial instruments were immaterial.

The Company has used management’s best estimates of fair values of financial instruments based on the above assumptions. This presentation does not include certain financial instruments, nonfinancial instruments or certain intangible assets such as customer relationships, deposit base intangibles, or goodwill. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The estimated fair values of financial instruments were as follows:

	June 30, 2009				December 31, 2008
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial assets:
Cash and due from banks	$	8,353	$	8,353	$	9,444	$	9,444
Interest-earning bank balances		31,120		31,120		613		613
Investment securities		97,452		97,738		109,180		108,751
Loans		629,962		640,389		626,688		639,505

Financial liabilities:
Deposits		616,233		605,840		581,488		577,876
Borrowed money		110,221		125,876		124,365		128,137

Note 10 – Subsequent Events

Subsequent events have been evaluated through August 13, 2009, which is the date the financial statements were available to be issued.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

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, changes in the level of non-performing assets and charge-offs, changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements, the level of future deposit premium assessments, our ability to raise capital to fund our growth plans or operations, the impact of the current governmental effort to restructure the U.S. financial and regulatory system, the quality and composition of the Company’s investment portfolio 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.

Executive Summary

Citizens South Banking Corporation is a Delaware corporation that owns all of the outstanding shares of common stock of Citizens South Bank (the "Bank"). The Company’s principal business activities are overseeing and directing the business of the Bank. The Company’s assets consist primarily of the outstanding capital stock of the Bank, deposits held at the Bank, and investment securities. The shares of common stock of the Company trade on the Nasdaq Global Market under the ticker symbol “CSBC.” Citizens South Bank, which was chartered in 1904, is a federally chartered savings bank headquartered in Gastonia, North Carolina. The Bank’s principal business activity is offering FDIC-insured deposits to local customers through its 15 branch offices and investing those deposits, together with funds generated from operations and borrowings, in residential and nonresidential real estate loans, construction loans, commercial business loans, consumer loans, investment securities, and mortgage-backed securities. The Bank also acts as a broker in both the origination of loans secured by one-to-four family dwellings and in the sale of uninsured financial products. The Bank’s results of operations are heavily dependent on net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings. Results of operations are also materially affected by the Bank’s provision for loan losses, noninterest income, and noninterest expense. Noninterest income includes fee income generated from deposit and loan accounts, mortgage banking fees, increases in the cash value of bank-owned life insurance policies, net gains (losses) from the sale of assets and other noninterest income items. The Bank’s noninterest expense primarily consists of compensation and employee benefits, occupancy expense, professional services, amortization of intangible assets, FDIC deposit insurance premiums and other noninterest expenses. Results of operations are also significantly affected by local economic and competitive conditions, changes in interest rates, and actions of regulatory and governmental authorities.

The following discussion is provided to assist in understanding and evaluating the Company’s results of operations and financial condition and is designed to provide a general overview of the Company’s performance for the three- and six-month periods ended June 30, 2009 and 2008. Readers seeking a more in-depth analysis should read the detailed discussions below, as well as the condensed consolidated financial statements and related notes. Financial highlights for the comparable periods are presented in the following table.

Financial Highlights: (unaudited) (Dollars in thousands, except per share data)	Three months ended June 30, 2009			Three months ended June 30, 2008			% Change			Six months ended June 30, 2009			Six months ended June 30, 2008			% Change

Summary Income Statement:
Interest income – taxable equivalent	$	9,819		$	10,619			(7.5	)%	$	19,650		$	21,715			(9.5	)%
Interest expense		4,346			5,571			(22.0	)		9,048			11,756			(23.0	)
Net interest income – taxable equivalent		5,473			5,048			8.4			10,602			9,959			6.5
Less: Taxable-equivalent adjustment		141			136			3.6			286			260			10.0
Net interest income		5,332			4,912			8.6			10,316			9,699			6.4
Provision for loan losses		(1,950	)		(750	)		160.0			(2,850	)		(1,095	)		160.3
Noninterest income		2,016			1,592			26.6			3,265			3,273			(0.3	)
Noninterest expense		(5,239	)		(4,702	)		11.4			(10,176	)		(9,585	)		6.2
Income tax (expense) benefit		155			(190	)		(181.6	)		216			(460	)		(147.0	)
Net income		314			862			(63.6	)		771			1,832			(57.9	)
Dividends on preferred stock		(259	)		-		NM				(513	)		-		NM
Net Income available to common stockholders	$	55		$	862			(93.6	)%	$	258		$	1,832			(85.9	)%

Per Common Share Data:
Earnings:
Basic	$	0.01		$	0.12			(91.7	)%	$	0.03		$	0.25			(88.0	)%
Diluted		0.01			0.12			(91.7	)		0.03			0.25			(88.0	)

Weighted average shares:
Basic		7,403,359			7,369,964			0.5	%		7,398,079			7,391,338			0.1	%
Diluted		7,403,359			7,434,006			(0.3	)		7,398,079			7,443,803			(0.6	)
End of period shares outstanding		7,526,854			7,524,016			0.4			7,526,854			7,524,016			0.4

Cash dividends paid	$	0.04		$	0.085			(52.9	)%	$	0.125			0.17			(26.5	)%
Book value		11.11			10.26			8.3			11.11			10.96			1.4
Tangible book value		7.07			6.88			2.8			7.07			6.88			2.8

End of Period Balances:
Total assets	$	836,283		$	811,825			3.0	%	$	836,283		$	811,825			3.0	%
Loans, net of deferred fees		629,962			604,855			4.2			629,962			604,855			4.2
Investment securities		97,452			117,613			(17.1	)		97,452			117,613			(17.1	)
Interest-earning assets		751,733			720,270			4.4			751,733			670,270			12.2
Deposits		616,233			584,801			5.4			616,233			584,801			5.4
Stockholders’ equity		104,158			82,495			26.3			104,158			82,495			26.7

Average Balances:
Total assets	$	841,169		$	790,625			6.4	%	$	832,937		$	783,148			6.4	%
Loans, net of deferred fees		635,645			588,868			7.9			631,184			577,953			9.2
Investment securities		107,140			110,903			(3.4	)		108,836			111,766			(2.6	)
Interest-earning assets		751,381			695,151			8.1			745,893			687,863			8.4
Deposits		616,936			578,469			6.7			605,046			624,136			4.5
Interest-bearing liabilities		685,109			655,533			4.5			678,699			646,204			5.0
Stockholders’ equity		104,813			83,965			24.8			104,875			84,205			24.6

Financial Performance Ratios:
Return on average assets		0.03	%		0.44	%		(93.2	)%		0.06	%		0.47	%		(87.2	)%
Return on average common equity		0.26			4.13			(93.7	)		0.62			4.38			(85.8	)
Noninterest income to average assets		0.96			0.81			18.3			0.78			0.84			(6.2	)
Noninterest expense to average assets		2.49			2.38			4.7			2.44			2.45			(0.2	)
Efficiency ratio		71.29			72.29			(1.4	)		75.58			73.89			2.3

NM = Not Meaningful

Financial Highlights: (unaudited) (Dollars in thousands, except per share data)	Three months ended June 30, 2009			Three months ended June 30, 2008			% Change			Six months ended June 30, 2009			Six months ended June 30, 2008			% Change

Net Interest Spread / Margin:
Yield on earnings assets		5.26	%		6.12	%		(14.1	)%		5.32	%		6.33	%		(16.0	)%
Cost of funds		2.54			3.41			(25.5	)		2.72			3.65			(25.5	)
Net interest spread		2.72			2.71			0.4			2.60			2.68			(3.0	)

Net interest margin		2.92			2.91			0.3			2.87			2.90			(1.0	)

Credit Quality Data:
Allowance for loan losses (ALLL):
Beginning of period	$	8,730		$	6,428			36.8	%	$	8,026		$	6,144			30.6	%
Add: Provision for loan losses		1,950			750			160.0			2,850			1,095			160.3
Less: Net charge-offs		1,995			421			373.8			2,191			482			354.6
Balance end of period		8,685			6,757			28.5			8,685			6,757			28.5

Nonperforming loans (NPLs)	$	10,360		$	3,880			167.0	%	$	10,360		$	3,880			167.0	%
Other real estate owned		2,111			635			232.4			2,111			635			232.4
Nonperforming assets (NPAs)		12,471			4,515			176.2			12,471			4,515			176.2

Allowance for loan losses to total loans		1.38	%		1.12	%		23.4	%		1.38	%		1.12	%		23.4	%
Net charge-offs to average loans		0.31			0.07			339.0			0.35			0.08			336.5
NPLs to total loans		1.64			0.64			156.4			1.64			0.64			156.4
NPAs to total assets		1.49			0.56			164.1			1.49			0.56			164.1
NPAs to total loans and OREO		1.97			0.75			164.6			1.97			0.75			164.6

Capital Ratios:
Tangible common equity		6.61	%		6.88	%		(3.9	)%		6.61	%		6.88	%		(3.9	)%
Bank-only regulatory capital ratios:
Tier 1		10.35			8.46			1.9			10.35			8.46			1.9
Total risk-based		14.31			10.84			3.5			14.31			10.84			3.5
Tier 1 risk-based		13.27			9.84			3.4			13.27			9.84			3.4
Tangible equity		10.35			8.46			1.9			10.35			8.46			1.9

Critical Accounting Policies

The accounting and financial policies of the Company and its subsidiaries are prepared in accordance with accounting principles generally accepted in the United States and conform to general practices in the banking industry. We consider accounting policies that require significant judgment and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. 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, the following accounting policies are considered critical to our financial results.

Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance sufficient to absorb estimated probable loan losses inherent in the Bank’s portfolio at the measurement date. Management’s determination of the adequacy of the allowance is based on quarterly evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the loss for each type of loan and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of the collateral. 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 collectability 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 collectability. 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. On at least a quarterly basis management 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 2007, the FASB issued Staff Position (“FSP”) FAS No. 115-1 and FAS No. 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,” FAS 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.”

In April 2009, the FASB issued FSP SFAS115-2 and SFAS 124-2 as outlined in Note 2. The issuance of these FSPs does not amend existing recognition and measurement guidance related to other-than-temporary impairment of equity securities.

During the second quarter of 2009 the FDIC placed Silverton Bank, the Company’s correspondent bank, into receivership. As a result, management determined that the Bank’s entire $91,000 equity investment in Silverton Bank was other-than-temporarily impaired. In accordance with SFAS No. 157, “Fair Value Measurements,” the Company uses valuation techniques that are appropriate and consistently applied. A fair value hierarchy is used to prioritize valuation inputs into the following three levels to determine fair value:

Level 1: Quoted prices in active markets for identical assets or liabilities.

Level 2: Observable inputs other than the quoted prices included in Level 1.

Level 3: Unobservable inputs.

Due to the lack of liquidity is this equity investment, the security was valued using Level 3. The fair value was prepared based on the Company’s most recent capital position and total common shares outstanding.

Effective June 30, 2009, management evaluated the Company’s investment portfolio and determined that all other unrealized losses were the direct result of temporary changes in interest rates and that such losses may be recovered in the foreseeable future. The Company has the ability to hold these investments to maturity if necessary in order to recover any temporary losses that may presently exist. As a result, management did not consider any additional unrealized losses as “other-than-temporary” as of June 30, 2009.

Comparison of Financial Condition

Assets. Total assets of the Company increased by $19.1 million, or 2.3%, from $817.2 million at December 31, 2008, to $836.3 million at June 30, 2009. This increase was primarily due to a $30.5 million increase in interest-earning bank balances and a $3.3 million increase in loans. These increases were partly offset by an $11.7 million decrease in total investment securities, a $644,000 decrease in Federal Home Loan Bank stock and a $490,000 decrease in other real estate owned.

Interest-earning bank balances, which includes the Bank’s deposits at the Federal Reserve Bank, increased by $30.5 million from $613,000 at December 31, 2008, to $31.1 million at June 30, 2009. This increase was primarily attributable to deposit growth of $34.7 million during the first six months of 2009. Management expects that the level of interest-bearing bank balances will be substantially reduced in the second half of 2009 as the excess liquidity from this deposit growth is invested in higher yielding loans and investment securities.

During the six-month period ended June 30, 2009, loans receivable increased by $3.3 million, or 0.5%, to $630.0 million. The growth in loans was primarily comprised of a $36.0 million, or 13.5%, increase in commercial real estate loans, a $10.2 million, or 29.7%, increase in commercial business loans, and a $1.7 million, or 1.6%, increase in consumer loans. These loan increases were partly offset by a $2.7 million, or 3.3%, decrease in permanent one-to-four family residential loans, a $34.0 million, or 47.6%, decrease in residential and commercial construction loans and a $10.0 million, or 18.7% reduction in residential acquisition and development loans. The decrease in construction loans was partly due to the conversion of several larger commercial projects from construction status to permanent status during the period, a decrease in local loan demand and a reduced interest by the Company to pursue these types of loans.

While the economy in the Charlotte region has generally outperformed most other large metropolitan areas of the country, the economy in the Charlotte region continued to slow during 2009. As a result, the Company’s loan production slowed to $75.7 million during the first six months of 2009 as compared to $158.7 million during the first six months of 2008. A continued slowdown in the local economy would have a negative impact on the Company’s ability to increase the current level of loan growth. 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 if the local economy continues to slow.

During the six-month period ended June 30, 2009, investment securities decreased by $11.7 million, or 10.7%, to $97.5 million. The decrease was primarily due to the sale of $21.6 million of investment securities and the normal maturities and principal amortization of $11.5 million. Also, during the period, the Company purchased $21.6 million of investments securities. Management expects the investment portfolio to increase as a percentage of total assets over the next quarter as the excess liquidity generated from deposit growth in the first quarter of 2009 is invested in higher-yielding assets.

Other real estate owned, which includes all properties acquired by the Company through foreclosure, totaled $2.1 million at June 30, 2009, compared to $2.6 million at December 31, 2008. At June 30, 2009, other real estate owned consisted of 12 one-to-four family residential dwellings and six residential lots. During the first six months of 2009, the Company foreclosed on five residential lots and six residential properties. Also, during the same period, the Company sold six foreclosed residential properties and one foreclosed commercial property for a loss of $308,000 and reduced the book value of two additional properties by $175,000 due to a drop in real estate prices for comparable properties. All foreclosed properties are written down to their estimated fair value (market value less estimated disposition costs) at acquisition and are located in the Bank’s primary lending area. Management will continue to aggressively market foreclosed properties for a timely disposition.

Premises and equipment decreased by $451,000, or 2.7%, to $16.4 million at June 30, 2009. This decrease was primarily due to normal depreciation. During the first quarter of 2009, the Company opened a loan production office located in a leased facility in Charlotte, North Carolina. This office is expected to transition into a full-service commercial branch catering mostly to commercial customers before the end of 2009. No significant changes to the Company’s premises and equipment are anticipated for the remainder of 2009.

Allowance for loan losses and nonperforming assets. The Company has established a systematic methodology for determining the adequacy of the allowance for loan losses. This methodology is set forth in a formal policy and considers all loans in the portfolio. Specific allowances are established for certain individual loans that management considers impaired. The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. Management’s periodic evaluation of the allowance is consistently applied and based on inherent losses in the portfolio, past loan loss experience, risks inherent in the different types of loans, the estimated value of any underlying collateral, current economic conditions, the borrower’s financial position, and other relevant internal and external factors that may affect loan collectibility. The allowance for loan losses is increased by charging provisions for loan losses against income. As of June 30, 2009, the allowance for loan losses was $8.7 million, or 1.38% 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.

	For the Three				For the Six
	Months Ended June 30,				Months Ended June 30,
	2009		2008		2009		2008
	(dollars in thousands)
Allowance for loan losses:
Beginning of period	$	8,730	$	6,427	$	8,026	$	6,145
Add:
Provision for loan losses		1,950		750		2,850		1,095
Recoveries		1		34		142		48
Less:
Charge-offs		1,996		455		2,333		531
End of period	$	8,685	$	6,757	$	8,685	$	6,757

	At June 30, 2009			At June 30, 2008
Nonperforming assets:
Nonperforming loans (1)	$	10,360		$	3,880
Other real estate owned		2,111			635
Nonperforming assets	$	12,471		$	4,515

Credit Quality Ratios:
Nonperforming loans to total loans		1.64	%		0.64	%
Nonperforming assets to total assets		1.49	%		0.56	%
Nonperforming assets to total loans and OREO		1.97	%		0.75	%
Allowance for loan losses as a percentage of total loans		1.38	%		1.12	%

(1) Nonperforming loans includes all loans that are 90 days or more delinquent and/or on nonaccrual status.

Liabilities. Total liabilities increased by $19.6 million, or 2.8%, from $712.5 million at December 31, 2008, to $732.1 million at June 30, 2009. This increase was primarily due to a $34.7 million increase in total deposits which was partly offset by an $14.1 million decrease in borrowed money.

During the first six months of 2009 total deposits increased by $34.7 million, or 6.0%, to $616.2 million at June 30, 2009. This increase in deposits was fueled in part by positive publicity that the Company received relating to our nationally recognized program for utilization of funds received from the U.S. Treasury CPP for low interest mortgage loans. The Company’s low interest rate mortgage program was featured in an article in The Washington Post and was subsequently covered by several other nationally recognized print and electronic media organizations. Our deposit growth was also partly due to a flight to safety as funds move from weaker financial institutions and brokerage accounts as well as a continued emphasis on increasing the Company’s number of retail and business customers through employee incentive plans and enhanced treasury service products. The deposit growth occurred in all categories of deposits. During the first six months of 2009 demand deposits (checking accounts) increased by $26.7 million, or 21.8%, to $149.5 million, money market deposit accounts increased by $7.5 million, or 7.3%, to $110.8 million, savings accounts increased by $448,000, or 4.2%, to $11.2 million and time deposits increased by $63,000, or 0.02%, to $344.8 million. 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. From time to time management may use brokered deposits as an alternative funding source for additional loan growth or liquidity needs. At June 30, 2009, brokered deposits totaled only $99,000.

Borrowed money decreased by $14.1 million, or 11.4%, to $110.2 million from December 31, 2008, to June 30, 2009. This decrease was primarily due to the repayment of short-term Federal Home Loan Bank (“FHLB”) advances that were obtained primarily for the purpose of funding loan growth. Funds generated from growth in deposits were used to repay these short-term FHLB advances. Additional borrowed money may be used in the future to fund additional loan growth, or purchase investment or mortgage-backed securities.

Stockholders’ Equity. Total stockholders’ equity decreased by $562,000, or 0.5% from $104.7 million at December 31, 2008 to $104.2 million at June 30, 2009. During the first six months of 2009, the Company paid $936,000 in dividends on common stock and had a $200,000 decrease in the unrealized gain on available-for-sale securities. The decrease in unrealized gains on available-for-sale securities was primarily due to increases in market interest rates during the period. These decreases in capital were partly offset by $258,000 of net income during the period.

Comparison of Results of Operations for the Three Months Ended June 30, 2009 and 2008

General. Net income available to common stockholders for the three months ended June 30, 2009, amounted to $55,000, or $0.01 per diluted share, as compared to $862,000, or $0.12 per diluted share, for the three months ended June 30, 2008. This decrease was largely due to increased credit losses arising as a result of a slowing economy and a special assessment by the FDIC which was charged to all FDIC-insured financial institutions.

Net interest income. Interest income decreased by $805,000, or 7.7%, to $9.7 million for the second quarter of 2009, primarily as a result of a 400 basis point decrease in short-term market interest rates during 2008. With approximately 47% of the Company’s loan portfolio scheduled to reprice on a monthly basis, the Company’s average yield on earning assets decreased by 86 basis points over the comparable periods to 5.26% for the quarter ended June 30, 2009. The Company was able to offset some of the negative effects of this decrease in yield through growth. Average interest-earning assets increased by $56.3 million, or 8.1%, to $751.4 million for the three months ended June 30, 2009. The increase in average interest-earning assets was primarily the result of a $46.8 million, or 7.9%, increase in average outstanding loans to $635.6 million.

Interest expense decreased by $1.2 million, or 22.0%, for the comparable periods to $4.3 million for the second quarter of 2009. This decrease in interest expense was largely due to lower market interest rates, which resulted in an 87 basis point decrease in the average cost of funds to 2.54% for the quarter ended June 30, 2009. This benefit of lower costing liabilities was partly offset by a $29.6 million, or 4.5%, increase in the average balance of interest-bearing liabilities to $685.1 million for the three months ended June 30, 2009. Average interest-bearing liabilities increased primarily as a result of a $37.2 million, or 6.9%, increase in average interest-bearing deposits offset by a $7.6 million, or 6.5%, decrease in average borrowed money.

The Company’s net interest margin increased by one basis point to 2.92% for the quarter ended June 30, 2009, compared to 2.91% for the quarter ended June 30, 2008. This slight increase in the net interest margin was the result of the cost of funds falling at a faster rate than the yield on assets. On a linked-quarter basis, the Company’s net interest margin increased 11 basis points from 2.81% for the first quarter of 2009 to 2.92% for the second quarter of 2009. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, the Federal Reserve Board’s action to lower short-term interest rates by 200 basis points in the fourth quarter of 2008 will have a more pronounced negative impact in the first three months following the decrease in short-term interest rates. 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. Due to the general weakness in the local economy and an increase in nonperforming assets, the Company increased its provision for loan losses to $2.0 million for the second quarter of 2009 compared to $750,000 for the second quarter of 2008. As a result, the allowance for loan losses was $8.7 million, or 1.38% of total loans, as of June 30, 2009, compared to $6.8 million, or 1.12% of total loans, as of June 30, 2008. While the Company’s credit quality continues to compare favorable with industry peers, the continued decline in local economic conditions has resulted in an upward trend in the Company’s loan delinquency ratios. The Company’s ratio of non-performing assets to total assets increased from 0.56% at June 30, 2008, to 1.49% at June 30, 2009. A substantial portion of the Company’s nonperforming loans at June 30, 2009, was secured by real estate located in the Company’s normal lending market. Net chargeoffs totaled $2.0 million, or 0.32% of average loans, during the second quarter of 2009 compared to $421,000, or 0.07% of average loans, during the second quarter of 2008. Management expects that the Company will continue to experience larger loan loss provisions over the foreseeable future.

Noninterest income. Noninterest income increased by $424,000, or 26.6%, to $2.0 million for the three months ended June 30, 2009, as compared to $1.6 million for the three months ended June 30, 2008. This increase was largely attributable to a $216,000 increase in the net gain on sale of assets during the comparable periods. During the second quarter of 2009 the Company sold two residential properties and one commercial property that were acquired through foreclosure at a net loss of $73,000 and $21.5 million in investment securities for a net gain of $308,000. During the second quarter of 2008 the Company recognized $19,000 in net gains from the sale of $117,000 of investment securities and $183,000 in foreclosed properties.

The remainder of the increase in noninterest income was primarily due to a $46,000 increase in fees on deposits, a $184,000 increase in mortgage banking fee income, and a $71,000 increase in other noninterest income. An increase in the number of demand deposit customers over the past year contributed to the improvement in deposit fee income. The increase in mortgage banking fee income was primarily due to increased refinancing activity in the housing market as a result of lower long-term mortgage rates for consumers. Other fee income increased primarily due to an increase in the fair value adjustment on deferred compensation assets, which is directly offset by a corresponding decrease in noninterest expense, resulting in no net impact on earnings.

These increases in noninterest income were partly offset by a $65,000 decrease in dividends on FHLB stock and a $22,000 decrease in fees on other loan fees. The FHLB suspended its dividend paid to stockholders in 2008, resulting in no dividend payment during 2009. It is unclear when, or if, the FHLB will reinstate the dividend. The reduction in other loan fee income was largely due to reduced construction loan activity resulting from the economic slowdown that is expected to last at least through 2009.

Noninterest expense. Noninterest expense increased by $537,000, or 11.4%, to $5.2 million for the quarter ended June 30, 2009. The primary reasons for this increase were a $474,000 increase in FDIC deposit insurance premiums, a $50,000 writedown on a foreclosed residential property and a $91,000 other-than-temporary impairment on an equity security. A portion of the increase in FDIC insurance premiums ($94,000) was due to the fact that the FDIC revised the formula for calculating deposit insurance premiums in an effort to replenish the deposit insurance fund, resulting in higher deposit insurance premiums for the Bank. These deposit premium increases are expected to continue throughout the foreseeable future. In addition, the FDIC charged all FDIC-insured financial institutions a special assessment of five basis points on total assets at June 30, 2009, which resulted in an additional premium expense of $380,000 for the second quarter of 2009. The FDIC may charge one or more additional special assessments in the future if needed. The writedown on the foreclosed property was the result of a softening in real estate sales prices for similarly priced properties located near the Company’s foreclosed property. This property has since been sold. Additional valuation adjustments on foreclosed properties may be recognized if sales prices for local properties continue to soften. The other-than-temporary impairment was on the Company’s equity investment in Silverton Bank, the Company’s correspondent bank which was taken into receivership by the FDIC during the second quarter of 2009. The Company has no additional exposure to Silverton Bank stock.

These increases in noninterest expense were partly offset by a $24,000 decrease in occupancy and equipment expense and a $54,000 decrease in the amortization of intangible assets. The decrease in occupancy and equipment expense was largely due to the expiration of depreciation expense related to the Company’s core processing system. The amortization of intangible assets is expected to continue to decrease as the amount of the core deposit intangible decreases.

Income taxes. Income taxes amounted to a benefit of $155,000 for the quarter ended June 30, 2009. This benefit was largely due to the fact that nontaxable income generated from interest earned on bank-qualified municipal securities and loans exceeded the Company’s provision for taxable income. This nontaxable income was primarily generated from interest earned on bank-qualified municipal securities and increases in cash value on bank-owned life insurance policies. 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. During the second quarter of 2008 the Company’s income tax expense totaled $190,000, or 18.1% of taxable income.

Comparison of Results of Operations for the Six Months Ended June 30, 2009 and 2008

General. Net income available to common stockholders for the six months ended June 30, 2009, amounted to $258,000, or $0.03 per diluted share, as compared to $1.8 million, or $0.25 per diluted share, for the six months ended June 30, 2008. This decrease was largely due to increased credit losses arising as a result of a slowing economy and a special assessment by the FDIC that was charged to all FDIC-insured financial institutions.

Net interest income. Interest income decreased by $2.1 million, or 9.7%, to $19.4 million for the first half of 2009, primarily as a result of a 400 basis point decrease in short-term market interest rates during 2008. With approximately 47% of the Company’s loan portfolio scheduled to reprice on a monthly basis, the Company’s average yield on earning assets decreased by 101 basis points for the comparable periods to 5.32% for the six months ended June 30, 2009. The Company was able to offset some of the negative effects of this decrease in yield through growth. Average interest-earning assets increased by $58.0 million, or 8.4%, to $745.9 million for the six months ended June 30, 2009. The increase in average interest-earning assets was primarily the result of a $53.2 million, or 9.2%, increase in average outstanding loans to $631.2 million for the six month period ending June 30, 2009.

Interest expense decreased by $2.7 million, or 23.0%, for the comparable periods to $9.0 million for the first half of 2009. This decrease in interest expense was largely due to lower market interest rates, which resulted in a 93 basis points decrease in the average cost of funds to 2.72% for the six months ended June 30, 2009. This benefit of lower costing liabilities was partly offset by a $32.5 million, or 5.0%, increase in the average balance of interest-bearing liabilities to $678.7 million for the six months ended June 30, 2009. Average interest-bearing liabilities increased primarily as a result of a $24.2 million, or 4.5%, increase in average interest-bearing deposits offset by an $8.3 million, or 7.7%, increase in average borrowed money.

As a result of the decrease in interest rates during the comparable periods, the Company’s net interest margin decreased by three basis points to 2.87% for the six months ended June 30, 2009, compared to 2.90% for the six months ended June 30, 2008. 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. However, on a linked-quarter basis, the Company’s net interest margin increased by 11 basis points from 2.81% for the first quarter of 2009 to 2.92% for the second quarter of 2009. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, the Federal Reserve Board’s action to lower short-term interest rates by 200 basis points in the fourth quarter of 2008 have had a more pronounced negative impact during the first six months following the decrease in short-term interest rates. The short-term negative effects of the 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. Due to the general weakness in the local economy and an increase in nonperforming assets, the Company increased its provision for loan losses to $2.9 million for the first six months of 2009 compared to $1.1 million for the first six months of 2008. As a result, the allowance for loan losses was $8.7 million, or 1.38% of total loans, as of June 30, 2009, compared to $6.8 million, or 1.12% of total loans, as of June 30, 2008. While the Company’s credit quality continues to compare favorably with industry peers, the continued decline in local economic conditions has resulted in an upward trend in the Company’s loan delinquency ratios. The Company’s ratio of non-performing assets to total assets increased from 0.56% at June 30, 2008, to 1.49% at June 30, 2009. A substantial portion of the Company’s nonperforming loans at June 30, 2009, was secured by real estate located in the Company’s normal lending market. Net charge offs totaled $2.2 million, or 0.35% of average loans, during the first half of 2009 compared to $482,000, or 0.08% of average loans, during the first half of 2008. Management expects that the Company will continue to experience larger loan loss provisions over the foreseeable future.

Noninterest income. Noninterest income decreased by $8,000, or 0.2%, to $3.3 million for the six months ended June 30, 2009. This decrease was largely attributable to a $197,000 increase in the net gain on sale of assets for the comparable periods. During the first half of 2009 the Company sold six residential properties and one commercial property that were acquired through foreclosure at a net loss of $244,000 and $21.6 million in investment securities at a net gain of $308,000. During the first half of 2008 the Company recognized $283,000 in net gains from the sale of $25.9 million in investment securities and $22,000 in net losses from the sale of $183,000 in foreclosed properties.

The remainder of this increase in noninterest income was partly due to a $115,000 increase in fees on deposits and a $279,000 increase in mortgage banking fee income. An increase in the number of demand deposit customers over the past year contributed to the improvement in deposit fee income. The increase in mortgage banking fee income was primarily due to increased refinancing activity in the housing market as a result of lower long-term mortgage rates for consumers.

We also experienced a $128,000 decrease in dividends on FHLB stock and a $75,000 decrease in other loan fees. The FHLB suspended its dividend paid to stockholders in 2008, resulting in no dividend payments during 2009. It is unclear when, or if, the FHLB will reinstate the dividend. The reduction in fee income from lending activities was largely due to reduced construction loan activity resulting from the economic slowdown that is expected to last at least through 2009.

Noninterest expense. Noninterest expense increased by $591,000, or 6.2%, to $10.2 million for the six months ended June 30, 2009. The primary reasons for this increase were a $175,000 writedown on a foreclosed residential property, a $214,000 other-than-temporary impairment on two equity securities, a $559,000 increase in FDIC deposit insurance premiums, and a $36,000 increase in professional fees. The writedown on the foreclosed property was the result of a softening in residential sales prices for similarly priced properties located near the Company’s foreclosed property. Additional valuation adjustments on foreclosed properties may be recognized if sales prices for local properties continue to soften. The other-than-temporary impairment was on two equity investments. The first equity investment was common stock in Silverton Bank, the Company’s correspondent bank, which was taken into receivership by the FDIC during the second quarter of 2009. The other equity investment was common stock in a closely held trust company that was determined to be other-than-temporarily impaired due to declining balances of assets under management and a declining customer base. A portion of the increase in FDIC insurance premiums ($180,000) was due to the fact that the FDIC revised the formula for calculating deposit insurance premiums in an effort to replenish the deposit insurance fund, resulting in higher deposit insurance premiums for the Bank. These deposit premium increases are expected to continue throughout the foreseeable future. In addition, the FDIC charged all FDIC-insured financial institutions a special assessment of five basis points on total assets at June 30, 2009, to which resulted in an additional premium expense of $380,000 for the second quarter of 2009. The FDIC may charge one or more additional special assessment in the future if needed. The increase in professional fees was partly due to increased legal fees paid for services related to ensuring compliance with TARP restrictions.

These increases in noninterest expense were partly offset by a $220,000 reduction in restructuring expenses, a $29,000 reduction in compensation and benefits, a $114,000 decrease in the amortization of intangible assets, and a $25,000 reduction in occupancy and equipment expense. The restructuring expense was attributable to severance payments made to various employees whose positions were eliminated during the first quarter of 2008. As a part of the restructuring, four positions were eliminated and six leased loan production offices were consolidated into existing facilities. No additional expenses are expected in conjunction with the reorganization. As a result of this reorganization in 2008, the Company’s compensation and benefits decreased during the first half of 2009, as compared to the first half 2008. The amortization of intangible assets is expected to continue to decrease as the amount of the core deposit intangible decreases. The decrease in occupancy and equipment expense was largely due to the expiration of depreciation expense related to the Company’s core processing system.

Income taxes. Income taxes amounted to a benefit of $216,000 for the six months ended June 30, 2009. This benefit was largely due to the fact that nontaxable income generated from interest earned on bank-qualified municipal securities and loans exceeded the Company’s provision for taxable income. This nontaxable income was primarily generated from interest earned on bank-qualified municipal securities and increases in cash value on bank-owned life insurance policies. 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. During the first half of 2008 the Company’s income tax expense totaled $460,000, or 20.1% of taxable income.

Liquidity

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 $82.3 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, or Enterprises) 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 $16.0 million available from an unsecured federal funds accommodation with Pacific Coast Bankers Bank (“PCBB”). PCBB is the Company’s primary correspondent bank. The federal funds facility 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 facility are generally repaid on a daily basis at a rate determined by PCBB based on their marginal cost of funds. Advances are limited to not more than 10 consecutive days at a time. The Company may also solicit brokered deposits for providing funds for asset growth. As of June 30, 2009, the Company had outstanding brokered deposits of $99,000. 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 June 30, 2009, the Company had loan commitments of $27.1 million, unused lines of credit of $95.6 million, and undisbursed construction loan proceeds of $1.4 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.

Capital Resources

On December 12, 2008, Citizens South Banking Corporation entered into a Letter Agreement (the "Purchase Agreement") with the U.S. Treasury pursuant to which the Company has issued and sold to the U.S. Treasury: (i) 20,500 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share, having a liquidation amount per share equal to $1,000, for a total price of $20,500,000 and (ii) a warrant to purchase 428,870 shares of the Company's common stock, par value $0.01 per share, at an exercise price per share of $7.17. The warrant has a ten-year term and is immediately exercisable. The warrant provides for the adjustment of the exercise price and the number of shares of the Company's common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of the Company's common stock, and upon certain issuances of the Company's common stock at or below a specified price relative to the then current market price of the Company's common stock. If, on or prior to December 31, 2009, the Company receives aggregate gross cash proceeds of not less than the purchase price of the Series A Preferred Stock from one or more "qualified equity offerings," the number of shares of common stock issuable pursuant to the Warrant will be reduced by one-half of the original number of shares, taking into account all adjustments. Pursuant to the Purchase Agreement, the U.S. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant. Both the Series A Preferred Stock and warrant are accounted for as components of Tier 1 capital.

The Series A Preferred Stock pays cumulative dividends at a rate of 5% per annum for the first five years and thereafter at a rate of 9% per annum. The Series A Preferred Stock can be repaid at any time from non-equity sources with the approval of the OTS. The Series A Preferred Stock is generally non-voting. Prior to December 12, 2011, and unless the Company has redeemed all of the Series A Preferred Stock or the U.S. Treasury has transferred all of the Series A Preferred Stock to a third party, the approval of the U.S. Treasury will be required for the Company to increase its common stock dividend or repurchase its common stock or other equity or capital securities, other than in certain circumstances specified in the Purchase Agreement. In addition the U.S. Treasury placed certain restrictions on the amount and type of compensation that can be paid to certain senior level executives of the Company.

The Bank is subject to various regulatory capital requirements administered by the banking regulatory agencies. 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.

The Bank’s actual capital levels and regulatory capital ratios as of June 30, 2009, are presented in the following table.

Regulatory Capital Ratios:	Actual					Minimum Requirements to be Well Capitalized
(Dollars in Thousands)	Amount		Ratio			Amount		Ratio
Citizens South Bank:
Total Capital (to risk-weighted assets)	$	89,853		14.31	%	$	62,780		10.00	%
Tier 1 Capital (to risk-weighted assets)		83,287		13.27	%		37,668		6.00	%
Tier 1 Capital (to adjusted total assets)		83,287		10.35	%		40,250		5.00	%
Tangible Capital (to adjusted total assets)		83,287		10.35	%		24,150		3.00	%

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

As described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2008, asset/liability management involves the evaluation, monitoring and management of interest rate risk, liquidity and funding. While the Board of Directors has overall responsibility for the Company’s asset/liability management policies, the Bank’s Asset and Liability Committee monitors loan, investment, and liability portfolios to ensure comprehensive management of interest rate risk and adherence to the Bank’s policies. Management does not believe there has been any significant change in the overall sensitivity of its interest-earning assets and interest-bearing liabilities from the results presented in the Annual Report on Form 10-K for the year ended December 31, 2008.

ITEM 4. Controls and Procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures in accordance with Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon their evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and in timely alerting them to material information relating to the Company (or its consolidated subsidiaries) required to be filed in its periodic SEC filings.

There has been no change in the Company’s internal control over financial reporting identified in connection with the quarterly evaluation that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Company's business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits.

Item 1A. Risk Factors

In addition to the other information contained this Quarterly Report on Form 10-Q, the following risk factors represent material updates and additions to the risk factor previously disclosed in the Company’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2008, as filed with the Securities and Exchange Commission. Additional risks not presently known to us, or that we currently deem immaterial, may also adversely affect our business, financial condition or results of operations. Further, to the extent that any of the information contained in this Quarterly Report on Form 10-Q constitutes forward-looking statements, the risk factor set forth below also is a cautionary statement identifying important factors that could cause our actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of us.

We Hold Certain Intangible Assets that Could Be Classified as Impaired in The Future. If These Assets Are Considered To Be Either Partially or Fully Impaired in the Future, Our Earnings and the Book Values of These Assets Would Decrease.

Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” we are required to test our goodwill and core deposit intangible assets for impairment on a periodic basis. The impairment testing process considers a variety of factors, including the current market price of our common shares, the estimated net present value of our assets and liabilities and information concerning the terminal valuation of similarly situated insured depository institutions. It is possible that future impairment testing could result in a partial or full impairment of the value of our goodwill or core deposit intangible assets, or both. If an impairment determination is made in a future reporting period, our earnings and the book value of these intangible assets will be reduced by the amount of the impairment. If an impairment loss is recorded, it will have little or no impact on the tangible book value of our shares of common stock or our regulatory capital levels.

Any Future Increases in FDIC Insurance Premiums Will Adversely Impact Our Earnings.

On May 22, 2009, the FDIC adopted a final rule levying a five basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The special assessment is payable on September 30, 2009. We recorded an expense of $380,000 during the quarter ended June 30, 2009, to reflect the special assessment. The final rule permits the FDIC’s Board of Directors to levy up to two additional special assessments of up to five basis points each during 2009 if the FDIC estimates that the Deposit Insurance Fund reserve ratio will fall to a level that the FDIC’s Board of Directors believes would adversely affect public confidence or to a level that will be close to or below zero. The FDIC has publicly announced that it is probable that it will levy an additional special assessment of up to five basis points later in 2009, the amount and timing of which are currently uncertain. Any further special assessments that the FDIC levies will be recorded as an expense during the appropriate period. In addition, the FDIC materially increased the general assessment rate and, therefore, our FDIC general insurance premium expense will increase substantially compared to prior periods.

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

During the three-month period ended June 30, 2009, the Company did not repurchase any shares of common stock.

As of June 30, 2009, the Company had repurchased a total of 3,213,911 shares, or 35.5% of the 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 in June 2008, for the repurchase of up to 200,000 shares, or approximately 2.7% of the Company’s then outstanding shares of common stock. As of June 30, 2009, 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 under this plan. On December 12, 2008, the Company entered into a Letter Agreement with the U.S. Treasury pursuant to which the Company has issued and sold to the U.S. Treasury: (i) 20,500 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share, having a liquidation amount per share equal to $1,000, for a total price of $20,500,000 and (ii) a warrant to purchase 428,870 shares of the Company's common stock, par value $0.01 per share, at an exercise price per share of $7.17. As a condition for issuing the preferred stock, the U.S. Treasury limited the Company’s ability to repurchase common stock of the Company and increase its dividend payments to stockholders without receiving prior approval from the U.S. Treasury. As a result, future repurchases of Company common stock are not anticipated for 2009.

Item 3. Defaults Upon Senior Securities

None.

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

The following proposals were considered and acted upon at the Annual Meeting of Stockholders of the Company held on May 11, 2009:

Proposal 1: The election of two Directors to the Board of Directors for a term of three years and until his successor has been elected and qualified.

	For	Withheld	Voted in Favor
Senator David W. Hoyle	5,903,453	68,542	98.9%
Ben R. Rudisill, II	5,890,006	81,989	98.6%

Proposal 2: The approval of an advisory, non-binding proposal to approve our executive compensation programs and policies.

		For		Against		Abstain
		5,628,597		267,413		75,985

Proposal 3: The ratification of the appointment of Cherry, Bekaert & Holland, L.L.P., as the independent registered public accounting firm for the Company for the fiscal year ending December 31, 2009.

		For		Against		Abstain
		5,952,805		5,450		13,740

Item 5. Other Information

None.

Item 6. Exhibits

31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Written statement of Chief Executive Officer furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Written statement of Chief Financial Officer furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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

	Citizens South Banking Corporation

Date: August 13, 2009	By:	/s/ Kim S. Price
		Kim S. Price
		President and Chief Executive Officer

Date: August 13, 2009	By:	/s/ Gary F. Hoskins
		Gary F. Hoskins
		Executive Vice President, Chief Financial Officer
		and Treasurer