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, 2012

or

[  ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ______ to _____

Commission File 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)	(Zip code)

(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 [x]  No [  ]

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

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 14, 2012, there were 11,506,324 shares outstanding of the Registrant’s common stock, $0.01 par value.

Citizens South Banking Corporation

Index

		Page
Part I.  FINANCIAL INFORMATION
Item 1.   Financial Statements (unaudited)
	Condensed Consolidated Statements of Financial Condition at June 30, 2012 and December 31, 2011	1
	Condensed Consolidated Statements of Operations for the Three and Six months Ended June 30, 2012 and 2011	2
	Condensed Consolidated Statements of Comprehensive Income for the Three and Six months Ended June 30, 2012 and 2011	3
	Condensed Consolidated Statements of Shareholders’ Equity for the Six months  Ended June 30, 2012 and 2011	4
	Condensed Consolidated Statements of Cash Flows for the Six months Ended June 30, 2012 and 2011	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.  Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations		30
Item 3. Quantitative and Qualitative Disclosures About Market Risk		44
Item 4.  Controls and Procedures		45
Part II.  OTHER INFORMATION
Item 1.  Legal Proceedings		45
Item 1A.  Risk Factors		45
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds		45
Item 3.  Defaults Upon Senior Securities		45
Item 4.  Mine Safety Disclosures		45
Item 5.  Other Information		45
Item 6.  Exhibits		45
Signatures
Certifications

Part I. FINANCIAL INFORMATION

Item 1.  Financial Statements

CITIZENS SOUTH BANKING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

	June 30, 2012			December 31, 2011 *
(Dollars in thousands, except share and per share data)	(unaudited)
ASSETS
Cash and cash equivalents:
Cash and due from banks	$	11,839		$	13,296
Interest bearing deposits		116,985			75,048
Cash and cash equivalents		128,824			88,344
Investment securities available for sale, at fair value		18,358			52,136
Investment securities held to maturity, at amortized cost		82,276			95,763
Federal Home Loan Bank stock, at cost		4,443			5,067
Presold loans in process of settlement		2,146			2,146
Loans:
Covered by FDIC loss-share agreements		128,874			159,688
Not covered by FDIC loss-share agreements		587,498			574,100
Loans, net of deferred fees and costs		716,372			733,788
Allowance for loan losses		(11,735	)		(11,713	)
Loans, net		704,637			722,075
Other real estate owned		21,405			17,571
Premises and equipment, net		25,396			25,888
FDIC loss share receivable		28,863			38,931
Accrued interest receivable		1,840			2,773
Bank-owned life insurance		18,723			18,978
Intangible assets		1,141			1,373
Other assets		11,125			9,415
Total assets	$	1,049,177		$	1,080,460
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits	$	852,764		$	876,056
Securities sold under repurchase agreements		7,554			9,787
Borrowed money		76,706			78,688
Subordinated debt		15,464			15,464
Other liabilities		7,216			7,806
Total liabilities		959,704			987,801
Shareholders' Equity
Preferred stock, $0.01 par value, Authorized: 1,000,000 shares; Issued and outstanding: 20,500 shares		20,500			20,500
Common stock, $0.01 par value, Authorized: 20,000,000 shares; Issued: 11,561,464 shares; Outstanding: 11,506,324 shares at June 30, 2012 and December 31, 2011		124			124
Additional paid-in-capital		64,209			63,888
Retained earnings, substantially restricted		4,647			7,854
Accumulated other comprehensive income (loss)		(7	)		293
Total shareholders' equity		89,473			92,659
Total liabilities and shareholders' equity	$	1,049,177		$	1,080,460

* Derived from audited consolidated financial statements

See accompanying notes to condensed consolidated financial statements.

1

CITIZENS SOUTH BANKING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
(Dollars in thousands, except per share data)
Interest Income
Interest and fees on loans	$	9,355		$	10,329		$	19,002		$	19,790
Investment securities:
Taxable interest income		606			983			1,343			1,776
Tax-exempt interest income		25			69			62			137
Other interest income		65			38			114			103
Total interest income		10,051			11,419			20,521			21,806
Interest Expense
Deposits		1,121			1,981			2,357			3,982
Repurchase agreements		7			19			14			37
Borrowed money		680			753			1,371			1,516
Subordinated debt		80			73			163			145
Total interest expense		1,888			2,826			3,905			5,680
Net interest income		8,163			8,593			16,616			16,126
Provision for loan losses		2,555			1,700			8,855			4,700
Net interest income after provision for loan losses		5,608			6,893			7,761			11,426
Noninterest Income
Service charges on deposit accounts		1,092			1,046			2,147			2,004
Mortgage banking income		393			254			710			491
Commissions on sales of financial products		67			69			153			136
Income from bank-owned life insurance		184			214			368			397
Gain (loss) from acquisition		(175	)		4,418			(175	)		4,163
Gain on sale of investments, available for sale		-			1			664			1
Gain (loss) on sale of other assets		85			(338	)		(53	)		(326	)
Other		1,054			222			1,608			500
Total noninterest income		2,700			5,886			5,422			7,366
Noninterest Expense
Compensation and benefits		3,902			3,806			7,748			7,454
Occupancy and equipment		898			873			1,806			1,701
Data processing and other technology		235			296			491			530
Professional services		308			249			583			502
Advertising and business development		74			71			142			125
Loan collection and other expenses		864			204			1,116			494
Deposit insurance		(49	)		361			369			695
Amortization of intangible assets		109			136			231			275
Office supplies		53			62			112			132
Telephone and communications		107			111			213			207
Other real estate owned valuation adjustments		1,784			1,476			2,784			1,984
Other real estate owned expenses		388			596			858			597
Acquisition and integration expenses		-			566			-			611
Other		859			463			1,767			1,638
Total noninterest expense		9,532			9,270			18,220			16,945
Income (Loss) before income tax expense (benefit)		(1,224	)		3,509			(5,037	)		1,847
Income tax expense (benefit)		(576	)		1,213			(2,249	)		442
Net income (loss)		(648	)		2,296			(2,788	)		1,405
Dividends on preferred stock		68			256			190			512
Net income (loss) allocable to common shareholders	$	(716	)	$	2,040		$	(2,978	)	$	893
Net income (loss) per common share - basic	$	(0.06	)	$	0.18		$	(0.26	)	$	0.08
Net income (loss) per common share - diluted		(0.06	)		0.18			(0.26	)		0.08

See accompanying notes to condensed consolidated financial statements.

2

CITIZENS SOUTH BANKING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
(Dollars in thousands)
Net income (loss)	$	(648	)	$	2,296		$	(2,788	)	$	1,405
Other comprehensive income (loss):
Investment securities, available for sale:
Unrealized holding gains arising during period		41			827			175			876
Tax expense		(16	)		(319	)		(67	)		(338	)
Reclassification for realized gains included in net income		-			(1	)		(664	)		(1	)
Tax benefit		-			-			256			-
Other comprehensive income (loss)		25			507			(300	)		537
Total comprehensive income (loss)	$	(623	)	$	2,803		$	(3,088	)	$	1,942

See accompanying notes to condensed consolidated financial statements.

3

CITIZENS SOUTH BANKING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (unaudited)

	Preferred Stock		Common Stock		Additional Paid-in Capital		Retained Earnings, Substantially Restricted			Accumulated Other Comprehensive Income (Loss)			Total Shareholders' Equity
(Dollars in thousands)
Balances, January 1, 2011	$	20,672	$	124	$	63,000	$	9,663		$	(16	)	$	93,443
Net income		-		-		-		1,405			-			1,405
Other comprehensive income, net of tax		-		-		-		-			538			538
Accretion of discount on preferred stock		41		-		-		(41	)		-			-
Allocation from shares purchased with loan to ESOP		-		-		22		-			-			22
Vesting of Recognition and Retention Plan ("RRP")		-		-		50		-			-			50
Stock-based compensation		-		-		53		-			-			53
Cash dividends on preferred stock, net of accretion		-		-		-		(512	)		-			(512	)
Cash dividends on common stock		-		-		-		(228	)		-			(228	)
														-
Balances, June 30, 2011	$	20,713	$	124	$	63,125	$	10,287		$	522		$	94,771
Balances, January 1, 2012	$	20,500	$	124	$	63,888	$	7,854		$	293		$	92,659
Net loss		-		-		-		(2,788	)		-			(2,788	)
Other comprehensive loss, net of tax		-		-		-		-			(300	)		(300	)
Allocation from shares purchased with loan to ESOP		-		-		25		-			-			25
Vesting of RRP		-		-		246		-			-			246
Stock-based compensation		-		-		50		-			-			50
Cash dividends on preferred stock		-		-		-		(190	)		-			(190	)
Cash dividends on common stock		-		-		-		(229	)		-			(229	)
														-
Balances, June 30, 2012	$	20,500	$	124	$	64,209	$	4,647		$	(7	)	$	89,473

See accompanying notes to condensed consolidated financial statements.

4

CITIZENS SOUTH BANKING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

	Six Months Ended June 30,
	2012			2011
(Dollars in thousands)
Cash flows from operating activities
Net income (loss)	$	(2,788	)	$	1,405
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Provision for loan losses		8,855			4,700
Depreciation of premises and equipment		649			645
Deferred income tax benefit		(1,363	)		(304	)
(Gain) loss on acquisition		175			(4,163	)
Gain on sale of investment securities available for sale		(664	)		(1	)
Loss on sale of other real estate owned and repossessed assets		53			326
Valuation adjustment on other real estate owned		2,784			1,984
Net purchase accounting adjustments		(13,072	)		5,828
Net decrease in presold loans in process of settlement		-			1,925
Deferred loan origination fees		117			101
Amortization of intangible assets		231			275
Allocation from shares purchased with loan to ESOP		25			22
Stock-based compensation		50			53
Vesting of shares issued for the RRP		246			50
Decrease in accrued interest receivable		932			223
Decrease in other assets		2,972			14,956
Decrease in other liabilities		(588	)		(1,178	)
Net cash provided by (used in) operating activities		(1,386	)		26,847
Cash flows from investing activities
Net decrease in loans made to customers		8,180			14,840
Proceeds from sales of investment securities available for sale		35,520			2,351
Proceeds from sales of other real estate owned		6,705			4,420
Proceeds from maturities/issuer calls of investment securities available for sale		13,745			5,607
Proceeds from maturities/issuer calls of investment securities held to maturity		26,691			6,594
Purchases of investment securities available for sale		(8,311	)		-
Purchases of investment securities held to maturity		(13,204	)		(48,714	)
Net cash received in acquisition		-			7,912
Redemption of FHLB stock		624			507
Purchases of premises and equipment		(157	)		(2,056	)
Net cash provided by (used in) investment activities		69,793			(8,539	)
Cash flows from financing activities
Net decrease in deposits		(23,542	)		(42,602	)
Dividends paid to common stockholders		(229	)		(228	)
Dividends paid to preferred stockholders		(190	)		(512	)
Net decrease in borrowed money and repurchase agreements		(4,216	)		(6,882	)
Increase in advances from borrowers for insurance and taxes		250			354
Net cash used in financing activities		(27,927	)		(49,870	)
Net increase (decrease) in cash and cash equivalents		40,480			(31,562	)
Cash and cash equivalents at beginning of year		88,344			120,899
Cash and cash equivalents at end of year	$	128,824		$	89,337
Supplemental non-cash investing activity
Loans transferred to other real estate owned	$	13,358		$	10,469

See accompanying notes to condensed consolidated financial statements.

5

CITIZENS SOUTH BANKING CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  In management’s opinion, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the interim financial statements as of and for the three- and six-month periods ended June 30, 2012 and 2011, and have been included as required by Regulation S-X Rule 10-01. They do not include all of the information and footnotes required by such accounting principles for complete financial statements, and therefore should be read in conjunction with the audited consolidated financial statements and accompanying footnotes in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The accompanying unaudited condensed consolidated financial statements include management estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  The more significant estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, other-than-temporary impairments on securities, and the fair value of acquired loans.  Actual results could differ from those estimates.

The accompanying unaudited condensed consolidated financial statements include the accounts of Citizens South Banking Corporation, its wholly-owned subsidiary, Citizens South Bank, and the Bank’s wholly-owned subsidiaries, Citizens South Financial Services, Inc. and Citizens Properties, LLC.  All significant intercompany accounts and transactions have been eliminated in consolidation.Certain of the prior year amounts have been reclassified to conform to current year presentation.  Such reclassifications were immaterial to the financial statements. Results for the three- and six-month periods ended June 30, 2012, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2012.

Note 2 – Merger with Park Sterling Corporation

On May 14, 2012, the Company announced the signing of a definitive merger agreement with Park Sterling Corporation (“Park Sterling”) under which Park Sterling will acquire Citizens South for a total value of approximately $77.8 million, excluding the exchange of $20.5 million in preferred stock issued to the United States Department of the Treasury in connection with Citizen South’s participation in the Small Business Lending Fund.The merger agreement has been unanimously approved by the board of directors of each company. Closing of the transaction, which is expected to occur in the fourth quarter of 2012, is subject to customary conditions, including approval by Citizens South’s shareholders, approval by Park Sterling’s shareholders and receipt of regulatory approval. Under the terms of the merger agreement, Citizens South shareholders will have the right to receive either $7.00 in cash or 1.4799 Park Sterling shares for each Citizens South share they hold, subject to the limitation that the total consideration will consist of 30.0% in cash and 70.0% in Park Sterling shares. Those Citizens South shares exchanged for stock will convert to Park Sterling shares in what is intended to be a tax-free exchange. Cash will also be paid in lieu of fractional shares. The transaction value at the time of the proposed merger may change due to potential fluctuations in the price of Park Sterling stock.

Note 3 - Recent Accounting Pronouncements

A summary of the accounting policies followed by the Company may be found in Note 1 – Organization and Summary of Significant Accounting Policies in the 2011 Annual Report on Form 10-K filed with the SEC.  Updates to the significant accounting policies are reported in the Company’s quarterly reports filed with the SEC on Form 10-Q as new or revised accounting pronouncements are made. The following paragraphs update that information for the second quarter of 2012.

6

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11 “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 requires an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Retrospective disclosure is required for all comparative periods presented. The Company does not expect an impact on its financial condition or results of operations.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to June 30, 2012. None of these new standards had or is expected to have a material impact on the Company’s consolidated financial statements.

Note 4 – Earnings per Common Share

The Company has presented both basic and diluted earnings per common share (“EPS”).  Basic EPS is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding for the period, without considering any dilutive items.  Diluted EPS is calculated by dividing net income (loss) available to common shareholders by the sum of the weighted average number of common shares outstanding for the period and common stock equivalents for items that are dilutive, net of shares assumed to be repurchased using the treasury method.

The potential common stock of the Company includes stock options and unvested shares issued for the Recognition and Retention Plan (“RRP”) granted to various directors and officers of the Bank and unexercised warrants issued to the U.S. Treasury. The Company excluded 659,794 outstanding options for the three- and six-month periods ended June 30, 2012, and 745,602 outstanding options for the three- and six-month periods ended June 30, 2011.  In addition, the exercise price of all of these options exceeded the average closing price of the shares of common stock during the three and six month periods ended June 30, 2012 and 2011 and, accordingly would have been anti-dilutive and therefore excluded from the diluted EPS calculation. At June 30, 2011, all of the 450,314 warrants had an exercise price which was in excess of the market value of the stock, so no warrants were included in the calculation of diluted earnings per share for this period since they would have also been anti-dilutive.  There were no warrants outstanding at June 30, 2012.

The following is a reconciliation of the diluted earnings per share calculation for the three- and six-month periods ended June 30, 2012 and 2011:

	Three Months Ended June 30,					Six Months Ended June 30,
	2012			2011		2012			2011
	(Dollars in thousands, except per share amounts)
Net income (loss) allocable to common shareholders	$	(716	)	$	2,040	$	(2,978	)	$	893
Weighted average number of shares outstanding		11,463,396			11,455,642		11,460,110			11,451,619
Basic net income (loss) per common share	$	(0.06	)	$	0.18	$	(0.26	)	$	0.08
Net income (loss) allocable to common shareholders	$	(716	)	$	2,040	$	(2,978	)	$	893
Weighted average number of shares outstanding		11,463,396			11,455,642		11,460,110			11,451,619
Incremental shares from assumed exercise of stock options and warrants		-			-		-			-
Weighted average number of shares outstanding - diluted		11,463,396			11,455,642		11,460,110			11,451,619
Diluted net income (loss) per common share	$	(0.06	)	$	0.18	$	(0.26	)	$	0.08

7

Note 5 – Investment Securities

The following is a summary of the amortized cost, unrealized gains and losses, and estimated fair value of the investment securities portfolio at June 30, 2012 and December 31, 2011 by major classification:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
	(Dollars in thousands)
June 30, 2012
Available for Sale:
Municipal bonds	$	1,675	$	3	$	-	$	1,678
Mortgage-backed securities		14,994		74		13		15,055
Other securities		1,701		44		120		1,625
Subtotal		18,370		121		133		18,358
Held to Maturity:
U.S. Treasury obligations		9,981		38		0		10,019
U.S. Government Agency obligations		13,996		59		-		14,055
Municipal bonds		3,272		91		-		3,363
Mortgage-backed securities		45,992		2,499		-		48,491
SBA securities		5,035		70		-		5,105
Other securities		4,000		-		186		3,814
Subtotal		82,276		2,757		186		84,847
Total investment securities	$	100,646	$	2,878	$	319	$	103,205
December 31, 2011
Available for Sale:
U.S. Government Agency obligations	$	7,168	$	73	$	-	$	7,241
Municipal bonds		6,578		133		-		6,711
Mortgage-backed securities		35,170		330		8		35,492
SBA securities		1,255		71		-		1,326
Other securities		1,488		44		166		1,366
Subtotal		51,659		651		174		52,136
Held to Maturity:
U.S. Treasury obligations		9,972		61		-		10,033
U.S. Government Agency obligations		25,989		74		4		26,059
Municipal bonds		3,300		99		-		3,399
Mortgage-backed securities		52,502		2,277		-		54,779
Other securities		4,000		-		155		3,845
Subtotal		95,763		2,511		159		98,115
Total investment securities	$	147,422	$	3,162	$	333	$	150,251

The amortized cost and estimated fair value of investment securities available for sale and held to maturity at June 30, 2012, by contractual maturity are shown in the following table. Actual maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

8

	Amortized Cost		Fair Value
	(Dollars in thousands)
Available for Sale:
Due in one year or less	$	3,181	$	3,188
Due after one year through five years		4,365		4,384
Due after five years through ten years		3,333		3,363
Due after ten years		5,804		5,856
Equities		1,687		1,567
Total	$	18,370	$	18,358
Held to Maturity:
		-		-
Due in one year or less	$	14,865	$	15,170
Due after one year through five years		29,996		30,607
Due after five years through ten years		25,350		25,733
Due after ten years		12,065		13,337
Total	$	82,276	$	84,847

9

The following table shows the amount of the fair values and gross unrealized losses of the investment securities by investment types segregated between those that have been in a continuous unrealized-loss position for less than twelve months and those investments that have been in a continuous unrealized-loss position for more than twelve months at June 30, 2012 and December 31, 2011.  At June 30, 2012, the unrealized losses related to four mortgage-backed securities, four corporate bonds and two equity securities. Of these ten securities, five have been in a continuous unrealized-loss position for more than 12 months.  At December 31, 2011, the unrealized losses related to one U.S. Government Agency obligation, six mortgage-backed securities and six other securities.  Of these thirteen securities, five have been in a continuous unrealized-loss position for more than 12 months.

Management periodically evaluated each investment security for other than temporary impairment, relying primarily on industry analyst reports, market conditions, and interest rate fluctuations. As of June 30, 2012, and December 31, 2011, management concluded that the unrealized losses presented in the table below were temporary in nature since the unrealized losses were largely attributable to changes in interest rates and not a deterioration of the credit quality of the issuers.  Also, the Company has the intent and ability to hold these investment securities until maturity or until such unrealized losses are eliminated.

	Less Than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(Dollars in thousands)
June 30, 2012
Available for Sale:
Mortgage-backed securities	$	3,493	$	13	$	-	$	-	$	3,493	$	13
Other securities		-		-		240		120		240		120
Subtotal		3,493		13		240		120		3,733		133
Held to Maturity:
Other securities		896		104		2,918		82		3,814		186
Subtotal		896		104		2,918		82		3,814		186
Total temporarily impaired securities	$	4,389	$	117	$	3,158	$	202	$	7,547	$	319
December 31, 2011
Available for Sale:
Mortgage-backed securities	$	4,619	$	8	$	88	$	-	$	4,707	$	8
Other securities		165		93		29		73		194		166
Subtotal		4,784		101		117		73		4,901		174
Held to Maturity:
U.S. Government Agency obligations		1,996		4		-		-		1,996		4
Other securities		997		3		2,848		152		3,845		155
Subtotal		2,993		7		2,848		152		5,841		159
Total temporarily impaired securities	$	7,777	$	108	$	2,965	$	225	$	10,742	$	333

From time to time the Company will pledge investment securities as collateral to secure public deposits and for other purposes as required or allowed by law.  The amortized cost of these pledged investment securities was $78.1 million at June 30, 2012, and $82.1 million at December 31, 2011.

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Note 6 - Loans

The Company makes various business and consumer loans in the normal course of business.  A brief description of these types of loans is as follows:

One-to-four family residential – This portfolio primarily consists of loans secured by residential properties located in the Company’s normal lending area.  These are amortizing loans with either fixed or adjustable rates for terms of 10 to 30 years, including conventional and jumbo loans.  These loans generally have an original loan-to-value ratio (“LTV”) of 80% or less.  Those loans with an initial LTV of more than 80% typically have private mortgage insurance to protect the Company.  This type of loan has historically possessed a lower than average level of loss to the Company compared to the Company’s entire loan portfolio.

Multifamily residential – This portfolio is moderately seasoned and is generally secured by multifamily residential properties in the Company’s normal lending area.  These loans generally have an initial LTV of 75% and an initial debt service coverage ratio of 1.2x to 1.0x.  The Company has not experienced any significant losses in this loan portfolio over the past 24 months.

Construction – This portfolio has decreased significantly over the past several years as fewer construction loans have been made during the economic downturn.  These loans are generally located in the Company’s normal lending area and were originated with an initial LTV of 80%.  Approximately 57% of these loans are secured by residential properties and 43% are secured by commercial properties.  The Company has not experienced any significant losses in this loan portfolio over the past 24 months.

Commercial land and residential development – These categories include raw undeveloped land and developed residential lots held by builders and developers.  Generally, the initial LTV for raw land was 65% and the initial LTV for developed lots was 90%.  Given the significant decline in value for both developed and undeveloped land due to reduced demand, these loan portfolios possess a much higher level of risk compared to other loan categories.  These portfolios have experienced the highest level of losses for the Company over the past 24 months.

Other commercial real estate – This portfolio consists of nonresidential improved real estate which includes churches, shopping centers, office buildings, etc.  These loans typically have an initial LTV of 75% and an initial debt service ratio of 1.2x to 1.0x.  Approximately 43% of this portfolio is secured by owner-occupied nonresidential properties.  These properties are generally located in the Company’s normal lending area.  Decreased rental income due to the economic slowdown has caused some deterioration in collateral values.   However, this loan portfolio has historically possessed a slightly lower than average loan loss ratio compared to the Company’s entire loan portfolio over the past 24 months.

Consumer real estate – Approximately 85% of this category includes home equity lines of credit (“HELOCs”) and approximately 15% of these loans are secured by residential lots purchased by consumers.  The HELOCs generally have an adjustable rate tied to prime rate and a term of 15 years.  The HELOCs initially had an LTV of up to 85%.  The residential lot loans typically have a term of five years or less and were made at an initial LTV of up to 90%.  Many of these properties have declined in value over the past several years.  The portfolio of consumer lot loans has experienced a higher than average level of loan losses over the past 24 months.  However, the portfolio of HELOCs has experienced a lower than average loan loss ratio over the past 24 months.

Commercial business – This category includes loans to small and medium-sized businesses that are not secured by real estate.  These loans are typically secured by accounts receivable, inventory, equipment, etc.  These loans are typically granted to local businesses that have a strong track record of profitability and performance.  This category of loans incurred slightly lower than average losses for the Company over the past 24 months.

Other consumer - These loans are either unsecured or secured by automobiles, marketable securities, etc.  They are generally granted to local customers that have an established banking relationship with our Bank.  The loss history for this category of loans has been much lower than the Company’s historical average over the past 24 months.

11

The following is a summary of loans outstanding by category at the periods presented:

	June 30, 2012						December 31, 2011
	Loans Covered by FDIC Loss Share Agreements		Loans Not Covered by FDIC Loss Share Agreements		Total		Loans Covered by FDIC Loss Share Agreements		Loans Not Covered by FDIC Loss Share Agreements		Total
	(Dollars in thousands)
Real estate:
One-to-four family residential	$	29,026	$	114,321	$	143,347	$	34,641	$	116,859	$	151,500
Multifamily residential		2,882		17,074		19,956		2,926		16,759		19,685
Construction		33		27,114		27,147		1,255		19,602		20,857
Commercial land		8,782		22,885		31,667		13,670		28,122		41,792
Residential development		6,026		10,068		16,094		8,095		16,444		24,539
Owner occupied commercial real estate		17,872		116,435		134,307		20,027		95,990		116,017
Non-owner occupied commercial real estate		47,344		131,840		179,184		56,285		129,993		186,278
Consumer real estate		9,457		99,162		108,619		11,148		103,521		114,669
Total real estate		121,422		538,899		660,321		148,047		527,290		675,337
Commercial business		4,795		43,635		48,430		7,866		41,161		49,027
Other consumer		2,657		4,964		7,621		3,775		5,649		9,424
Total loans, net of deferred fees and costs	$	128,874	$	587,498		716,372	$	159,688	$	574,100		733,788
Less: Allowance for loan losses						11,735						11,713
Total loans, net					$	704,637					$	722,075

The Company, through its normal lending activity, originates substantially all of its loans to borrowers that are located in the Piedmont (central) Region of North and South Carolina and the North Georgia Region. The Company also has presold loans in process of settlement which totaled $2.1 million at June 30, 2012 and December 31, 2011.  These presold loans in process of settlement were not included in the table above.

As of June 30, 2012, the Company had $128.9 million in loans covered by FDIC loss-share agreements as a result of the acquisition of loans from Bank of Hiawassee and New Horizons Bank in separate FDIC-assisted transactions (referred to as “covered loans”).  The loans acquired in the Bank of Hiawassee transaction in March 2010 are covered by two loss-share agreements between the FDIC and the Bank, which afford the Bank significant protection against future loan losses.  Under these loss-share agreements, the FDIC will cover 80% of net loan losses up to $102 million and 95% of net loan losses that exceed $102 million.  The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans and five years for losses and eight years on recoveries on nonresidential loans. At acquisition, the Bank recorded an estimated receivable from the FDIC in the amount of $36.3 million, which represented the discounted value of the FDIC’s estimated portion of the expected future loan losses.  New loans made after the acquisition date are not covered by the FDIC loss-share agreements. These covered loans totaled $93.7 million at June 30, 2012.

In April 2011 the Company acquired New Horizons Bank in an FDIC-assisted transaction.  As part of this transaction, the Company acquired $49.3 million in loans at fair value. Of the acquired loans, $47.4 million are covered by two loss-share agreements between the FDIC and the Bank.  Under these loss-share agreements, the FDIC will cover 80% of net loan losses and qualified expenses.  The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans and five years for losses and eight years on recoveries on nonresidential loans. At acquisition, the Bank recorded an estimated receivable from the FDIC in the amount of $19.9 million, which represented the discounted value of the FDIC’s estimated portion of the expected future loan losses.  The remaining $1.9 million in loans acquired in the New Horizons Bank transaction were not covered by FDIC loss-share agreements.  As such, any losses incurred on these non-covered loans will be the sole responsibility of the Bank. New loans made after the acquisition date are not covered by the FDIC loss-share agreements. These covered loans totaled $35.2 million at June 30, 2012.

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Note 7 – Credit Quality of Loans

Aging Analysis of Loans.  The Company considers a loan to be past due when the terms of the contractual obligation are not met by the borrower.  The following table presents an aging analysis of the Company’s loans not covered by FDIC loss-share agreements, loans covered by FDIC loss-share agreements and total loans summarizing current loans, past due loans, and nonaccrual loans by category at June 30, 2012 and December 31, 2011.

June 30, 2012	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due and Accruing		Nonaccrual		Total Past Due		Current		Total Loans		Recorded Investment 90 Days or More and Accruing
	(Dollars in thousands)
Not covered by FDIC loss-share agreements
Real estate:
One-to-four family residential	$	489	$	88	$	-	$	4,230	$	4,807	$	109,514	$	114,321	$	-
Multifamily residential		-		-		-		-		-		17,074		17,074		-
Construction		-		-		-		-		-		27,114		27,114		-
Commercial land		-		-		151		3,018		3,169		19,716		22,885		154
Residential development		-		-		-		3,000		3,000		7,068		10,068		-
Other commercial real estate		235		682		-		8,489		9,406		238,869		248,275		-
Consumer real estate		255		-		-		961		1,216		97,946		99,162		-
Total real estate		979		770		151		19,698		21,598		517,301		538,899		154
Commercial business		24		-		-		945		969		42,666		43,635		-
Other consumer		32		7		-		15		54		4,910		4,964		-
Total	$	1,035	$	777	$	151	$	20,658	$	22,621	$	564,877	$	587,498	$	154
Covered by FDIC loss-share agreements
Real estate:
One-to-four family residential	$	759	$	135	$	61	$	7,566	$	8,521	$	20,505	$	29,026	$	63
Multifamily residential		-		-		-		380		380		2,502		2,882		-
Construction		-		-		-		-		-		33		33		-
Commercial land		-		106		-		3,944		4,050		4,732		8,782		-
Residential development		-		-		-		3,759		3,759		2,267		6,026		-
Other commercial real estate		29		206		-		17,785		18,020		47,196		65,216		-
Consumer real estate		229		-		-		967		1,196		8,261		9,457		-
Total real estate		1,017		447		61		34,401		35,926		85,496		121,422		63
Commercial business		8		-		163		1,422		1,593		3,202		4,795		169
Other consumer		23		-		-		413		436		2,221		2,657		-
Total	$	1,048	$	447	$	224	$	36,236	$	37,955	$	90,919	$	128,874	$	232
Total at June 30, 2012
Real estate:
One-to-four family residential	$	1,248	$	223	$	61	$	11,796	$	13,328	$	130,019	$	143,347	$	63
Multifamily residential		-		-		-		380		380		19,576		19,956		-
Construction		-		-		-		-		-		27,147		27,147		-
Commercial land		-		106		151		6,962		7,219		24,448		31,667		154
Residential development		-		-		-		6,759		6,759		9,335		16,094		-
Other commercial real estate		264		888		-		26,274		27,426		286,065		313,491		-
Consumer real estate		484		-		-		1,928		2,412		106,207		108,619		-
Total real estate		1,996		1,217		212		54,099		57,524		602,797		660,321		217
Commercial business		32		-		163		2,367		2,562		45,868		48,430		169
Other consumer		55		7		-		428		490		7,131		7,621		-
Total	$	2,083	$	1,224	$	375	$	56,894	$	60,576	$	655,796	$	716,372	$	386

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December 31, 2011	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due and Accruing		Nonaccrual		Total Past Due		Current		Total Loans		Recorded Investment 90 Days or More and Accruing
	(Dollars in thousands)
Not covered by FDIC loss-share agreements
Real estate:
One-to-four family residential	$	80	$	1,634	$	-	$	2,407	$	4,121	$	112,738	$	116,859	$	-
Multifamily residential		-		-		-		-		-		16,759		16,759		-
Construction		-		93		-		-		93		19,509		19,602		-
Commercial land		-		-		-		2,631		2,631		25,491		28,122		-
Residential development		-		-		-		6,474		6,474		9,970		16,444		-
Other commercial real estate		81		1,873		-		4,173		6,127		219,856		225,983		-
Consumer real estate		761		388		335		2,543		4,027		99,494		103,521		338
Total real estate		922		3,988		335		18,228		23,473		503,817		527,290		338
Commercial business		7		-		-		168		175		40,986		41,161		-
Other consumer		13		3		-		80		96		5,553		5,649		-
Total	$	942	$	3,991	$	335	$	18,476	$	23,744	$	550,356	$	574,100	$	338
Covered by FDIC loss-share agreements
Real estate:
One-to-four family residential	$	1,530	$	2,220	$	215	$	8,441	$	12,406	$	22,235	$	34,641	$	219
Multifamily residential		-		-		-		216		216		2,710		2,926		-
Construction		-		-		-		1,191		1,191		64		1,255		-
Commercial land		140		11		10		6,704		6,865		6,805		13,670		11
Residential development		-		-		-		4,578		4,578		3,517		8,095		-
Other commercial real estate		351		466		495		17,454		18,766		57,546		76,312		511
Consumer real estate		236		15		-		634		885		10,263		11,148		-
Total real estate		2,257		2,712		720		39,218		44,907		103,140		148,047		741
Commercial business		90		39		23		3,484		3,636		4,230		7,866		24
Other consumer		141		133		57		554		885		2,890		3,775		58
Total	$	2,488	$	2,884	$	800	$	43,256	$	49,428	$	110,260	$	159,688	$	823
Total at December 31, 2011
Real estate:
One-to-four family residential	$	1,610	$	3,854	$	215	$	10,848	$	16,527	$	134,973	$	151,500	$	219
Multifamily residential		-		-		-		216		216		19,469		19,685		-
Construction		-		93		-		1,191		1,284		19,573		20,857		-
Commercial land		140		11		10		9,335		9,496		32,296		41,792		11
Residential development		-		-		-		11,052		11,052		13,487		24,539		-
Other commercial real estate		432		2,339		495		21,627		24,893		277,402		302,295		511
Consumer real estate		997		403		335		3,177		4,912		109,757		114,669		338
Total real estate		3,179		6,700		1,055		57,446		68,380		606,957		675,337		1,079
Commercial business		97		39		23		3,652		3,811		45,216		49,027		24
Other consumer		154		136		57		634		981		8,443		9,424		58
Total	$	3,430	$	6,875	$	1,135	$	61,732	$	73,172	$	660,616	$	733,788	$	1,161

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Troubled Debt Restructurings.  The Company adopted the amendments in Accounting Standards Update (“ASU”) No. 2011-02 Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, during the quarter ended September 30, 2011, and has reassessed all restructurings that occurred on or after the beginning of the 2011 fiscal year for identification as troubled debt restructurings (“TDRs”). The Company identified as TDRs certain receivables for which the allowance for credit losses had previously been measured under a general allowance for credit losses methodology (ASC 450-20). Upon identifying the reassessed receivables as TDRs, the Company also identified them as impaired under the new guidance in ASC 310-10-35. The amendments in ASU No. 2011-02 require prospective application of the impairment measurement guidance in Section 310-10-35 for those receivables newly identified as impaired. At the end of the second interim period of adoption for the Company, the recorded investment in the receivables for which the allowance for credit losses was previously measured under a general allowance for credit losses methodology and are now impaired under Section 310-10-35 was $1.3 million (310-40-65-1(b)), and there was no allowance for credit losses associated with those receivables, on the basis of a current evaluation of loss (310-40-65-1(b)).

The modification or restructuring of a debt constitutes a TDR if we, for economic or legal reasons related to the borrower’s financial difficulties, grant a concession to the borrowers that we would not otherwise consider. Some examples of modifications are described below:

Rate modification –  A modification in which only the interest rate is changed.

Term modification – A modification in which the maturity date, timing of payments, or frequency of payments is changed.

Interest only modification – A modification in which the loan is converted to interest only payments for a period of time.

Debt Reduction Modification – A modification in which a portion of the debt is reduced.

Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

Transfer of Assets Modification– A modification in which a transfer of assets has occurred to partially satisfy debt, including foreclosure and repossession.

Combination Modification – Any other type of modification, including the use of multiple categories above.

15

The following table presents the Bank’s loans classified as TDRs by loan type as of June 30, 2012 and December 31, 2011:

	Accrual Status		Non-accrual Status		Total Contracts		Total TDRs
	(Dollars in thousands)
June 30, 2012
One-to-four family residential	$	220	$	-	$	2	$	220
Commercial land		875		678		3		1,553
Residential development		-		141		1		141
Other commercial real estate		4,450		4,936		23		9,386
Commercial business		-		885		1		885
Total	$	5,545	$	6,640	$	30	$	12,185
December 31, 2011
One-to-four family residential	$	12	$	-		1	$	12
Commercial land		195		89		2		284
Residential development		633		-		2		633
Other commercial real estate		6,955		1,159		24		8,114
Total	$	7,795	$	1,248	$	29	$	9,043

The following table presents new TDRs that were restructured during the six months ended June 30, 2012, and June 30, 2011:

	Six Months Ended June 30, 2012						Six Months Ended June 30, 2011
	Total Number of Contracts		Pre-modification Outstanding Recorded Investment		Post-modification Outstanding Recorded Investment		Total Number of Contracts		Pre-modification Outstanding Recorded Investment		Post-modification Outstanding Recorded Investment
	(Dollars in thousands)
Interest only modification:
Commercial real estate		1		590		590		3		1,050		1,050
Subtotal		1	$	590	$	590		3	$	1,050	$	1,050
Term modification:
Residential real estate		1	$	208	$	208		-	$	-	$	-
Commercial business		-		-		-		3		598		598
Subtotal		1	$	208	$	208		3	$	598	$	598
Debt reduction reduction:
Commercial land		3	$	4,576	$	3,285		-	$	-	$	-
Subtotal		3	$	4,576	$	3,285		-	$	-	$	-
Total		5	$	5,374	$	4,083		6	$	1,648	$	1,648

All TDRs are not automatically placed on nonaccrual status.  Generally, those TDRs that are placed on non-accrual status may return to accrual status when the borrower has sustained repayment performance in accordance with the modified terms.  The number of payments needed to meet these criteria varies from loan to loan.  However, as a general rule, most non-accrual loans should be able to return to accrual status after the payment of six consecutive regular scheduled payments. During the six month period ended June 30, 2012, there were no payment defaults on any TDRs.  During the 12 month period ended December 31, 2011, there was one payment default on a residential TDR.  The collateral for this residential loan was acquired through foreclosure and was sold during the third quarter of 2011.  The loan had an original principal balance of $1.1 million and the resulting loss from disposition of the collateral was approximately $335,000.

16

Also, in the normal course of business, the Company will make loan restructurings or modifications to borrowers for reasons unrelated to the borrower’s financial condition.  These restructurings or modifications are made based on the prevailing interest rates and terms offered to other borrowers for similar types of loans at the time of the modification. These types of debt restructurings or loan modifications would not be considered troubled debt restructurings.

Impaired Loans.  The Company evaluates impairment of its non-covered residential mortgage and consumer loans on a collective basis, while non-covered commercial and construction loans are evaluated individually for impairment.  The Company identifies a non-covered loan as impaired when it is probable that principal and interest will not be collected when due according to the contractual terms of the loan agreement.  Principal write-downs may be recognized for individual non-covered loans that management considers impaired.  The remainder of the portfolio of non-covered loans is segmented into groups of loans with similar risk characteristics for evaluation and analysis. Since all estimated impairments resulted in principal writedowns, there were no specific related allowances for the impaired loans at June 30, 2012, or December 31, 2011.

The following table details the Company’s impaired loans by type at June 30, 2012, and December 31, 2011:

	June 30, 2012								December 31, 2011
	Recorded Investment		Unpaid Principal Balance		Net Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Net Principal Balance		Related Allowance
	(Dollars in thousands)
June 30, 2012
One-to-four family residential	$	4,696	$	5,143	$	4,488	$	-	$	2,781	$	2,739	$	2,739	$	-
Commercial land		3,355		4,343		3,194		-		3,062		4,523		2,826		-
Residential development		3,679		5,427		3,472		-		8,428		10,173		8,262		-
Commercial real estate - office		7,449		8,584		7,375		-		6,322		7,573		6,305		-
Commercial real estate - residential rental		2,288		2,933		2,244		-		4,076		4,808		4,029		-
Commercial real estate - owner-occupied		2,721		3,301		2,614		-		-		-		-		-
Commercial real estate - other		2,188		2,585		2,168		-		2,426		2,945		2,323		-
Consumer real estate		1,158		1,968		1,047		-		2,689		2,801		2,630		-
Commercial business		948		945		945		-		169		169		169		-
Other consumer		18		18		18		-		89		90		89		-
Total impaired loans	$	28,500	$	35,247	$	27,565	$	-	$	30,042	$	35,821	$	29,372	$	-

Credit Quality Indicators. We categorize loans using various credit quality indicators based on relevant information about the ability of borrowers to service their debts such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  We analyze loans individually by classifying the loans as to credit risk.  This analysis is performed on at least a quarterly basis.  We use the following definitions for credit quality indicators:

Pass - Loans in classes that comprise the commercial business and consumer segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. The Company’s portfolio of FDIC-covered loans was considered to be Pass rated loans at June 30, 2012, and December 31, 2011, as the loans were recorded at estimated fair value on the acquisition date and have FDIC loss-share agreements to cover at least 80% of any future losses.

Special Mention - Loans designated as special mention have potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of our credit position at some future date. Management believes that there is a moderate likelihood of some loss related to loans designated as Special Mention.

17

Substandard -  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified have one or more well-defined weaknesses that jeopardize the liquidation of the debt.  There is a distinct possibility that the Company will sustain some loss if the deficiencies on these loans are not corrected.

Doubtful -  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values highly questionable and improbable.

Loss – Loans classified as loss are considered to be completely uncollectable and as a result the loans have been completely written-off the books of the Company.   

As of June 30, 2012 and December 31, 2011, the credit quality indicators of loans were as follows:

	Pass		Special Mention		Substandard		Total
	(Dollars in thousands)
June 30, 2012
Real estate:
One-to-four family residential	$	138,184	$	483	$	4,680	$	143,347
Multifamily residential		18,901		1,055		-		19,956
Construction		27,147		-		-		27,147
Commercial land		25,296		720		5,651		31,667
Residential development		11,904		-		4,190		16,094
Owner occupied CRE		126,414		4,988		2,905		134,307
Other commercial real estate		153,500		15,846		9,838		179,184
Consumer land		15,479		200		516		16,195
Home equity lines of credit		89,853		1,294		1,277		92,424
Total real estate		606,678		24,586		29,057		660,321
Commercial business		47,138		244		1,048		48,430
Other consumer		7,416		168		37		7,621
Total loans	$	661,232	$	24,998	$	30,142	$	716,372
December 31, 2011
Real estate:
One-to-four family residential	$	149,013	$	562	$	1,925	$	151,500
Multifamily residential		19,685		-		-		19,685
Construction		20,857		-		-		20,857
Commercial land		30,202		8,600		2,990		41,792
Residential development		15,806		1,037		7,696		24,539
Other commercial real estate		269,970		19,925		12,400		302,295
Consumer land		17,356		458		1,560		19,374
Home equity lines of credit		92,752		790		1,753		95,295
Total real estate		615,641		31,372		28,324		675,337
Commercial business		48,477		254		296		49,027
Other consumer		9,147		170		107		9,424
Total loans	$	673,265	$	31,796	$	28,727	$	733,788

18

Note 8 - Allowance for Loan Losses

The Company has established a systematic methodology for determining the allowance for loan losses.  This methodology is set forth in a formal policy and considers all non-covered loans in the portfolio.    The two primary components of the Company’s loan loss methodology are as follows:

1)  Quantitative Reserve Component. Quantitative reserves represent the current loss contingency estimate on pools of loans, which is an estimate of the amount for which it is probable that the Company will be unable to collect all amounts due on homogeneous groups of loans according to contractual terms should one or more events occur, excluding those loans specifically identified above. This component of the allowance for loan losses is based on the historical loss experience of the Company. This loss experience was collected by evaluating internal loss data. The historical loss rates are grouped by loan product type. The Company utilizes average historical losses over the prior eight quarters in evaluating this component for all loan types.

2)  Qualitative Reserve Component. Qualitative reserves represent an estimate of the amount for which it is probable that environmental or other relevant factors will cause the loss contingency estimate to differ from the Company’s historical loss experience or other assumptions. The Company considers portfolio trends; portfolio concentrations; economic and market trends; changes in lending practices; and other factors to evaluate the need for qualitative adjustments.

A reconciliation of the allowance for loan losses for the three and six month periods ended June 30, 2012 and 2011 is as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Balance - Beginning of period	$	11,583		$	12,006		$	11,713		$	11,924
Charge-offs:
One-to-four family residential		(518	)		(312	)		(1,417	)		(1,137	)
Construction		-			(5	)		-			(41	)
Commercial land		(101	)		(291	)		(191	)		(2,244	)
Residential development		(313	)		(386	)		(2,805	)		(386	)
Other commercial real estate		(938	)		(256	)		(2,319	)		(256	)
Consumer real estate		(774	)		(35	)		(2,504	)		(91	)
Commercial business		(227	)		(35	)		(227	)		(188	)
Other consumer		(22	)		(5	)		(33	)		(18	)
Total charge-offs		(2,893	)		(1,325	)		(9,496	)		(4,361	)
Recoveries:
One-to-four family residential		35			4			68			7
Multifamily residential		4			-			4			-
Construction		2			181			-			231
Commercial land		119			-			119			-
Residential development		32			128			89			128
Other commercial real estate		235			30			314			14
Consumer real estate		59			2			61			9
Commercial business		1			10			3			13
Other consumer		3			6			5			77
Total recoveries		490			361			663			479
Provision for loan losses		2,555			1,700			8,855			4,700
Balance - End of period	$	11,735		$	12,742		$	11,735		$	12,742

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Loans totaling $128.9 million that were covered under the FDIC loss-share agreements were not included in the Company’s evaluation of the adequacy of loan loss allowances since potential losses are covered up to at least 80% by the FDIC.  These covered loans were recorded at their estimated fair value at the time of the acquisition.  Management evaluates the adequacy of the fair value of these acquired loans on a periodic basis to ensure that the existing values remain reasonable.  If the fair value of these loans is not considered adequate, then the principal balance of the loan is written down to the current fair value through a charge to the provision for loan losses on acquired loans.  The Company recognized loan loss provision expense on acquired loans in the amount of $505,000 for the six months ended June 30, 2012.  There was no such provision expense recognized during the six month period ended June 30, 2011.

The following table presents a disaggregated analysis of the activity in the allowance for loan losses and loan balances for non-covered loans for the three months ended June 30, 2012 and June 30, 2011.

	One-to-four family residential			Multifamily residential		Construction			Commercial land			Residential development			Other commercial real estate			Consumer real estate			Commercial business			Other consumer			Total
	(Dollars in thousands)
June 30, 2012
Allowance for loan losses
Balance - April 1, 2012	$	534		$	150	$	650		$	2,344		$	2,064		$	1,927		$	1,372		$	2,002		$	540		$	11,583
Charge-offs		(475	)		-		-			-			(232	)		(688	)		(759	)		(217	)		(11	)		(2,382	)
Recoveries		35			-		2			119			32			235			57			1			3			484
Provision		450			-		-			-			150			500			650			250			50			2,050
Balance - June 30, 2012	$	544		$	150	$	652		$	2,463		$	2,014		$	1,974		$	1,320		$	2,036		$	582		$	11,735
Loans individually evaluated for impairment	$	-		$	-	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Loans collectively evaluated for impairment	$	544		$	150	$	652		$	2,463		$	2,014		$	1,974		$	1,320		$	2,036		$	582		$	11,735
Loans
Loans individually evaluated for impairment	$	4,488		$	-	$	-		$	3,194		$	3,472		$	14,401		$	1,047		$	945		$	18		$	27,565
Loans collectively evaluated for impairment		109,833			17,074		27,114			19,691			6,596			233,874			98,115			42,690			4,946			559,933
Total non-covered loans	$	114,321		$	17,074	$	27,114		$	22,885		$	10,068		$	248,275		$	99,162		$	43,635		$	4,964		$	587,498
June 30, 2011
Allowance for loan losses
Balance - April 1, 2011	$	528		$	200	$	1,014		$	2,014		$	1,996		$	1,645		$	1,551		$	2,500		$	558		$	12,006
Charge-offs		(312	)		-		(5	)		(291	)		(386	)		(256	)		(35	)		(35	)		(5	)		(1,325	)
Recoveries		4			-		181			-			128			30			2			10			6			361
Provision		300			-		-			500			300			500			50			50			-			1,700
Balance - June 30, 2011	$	520		$	200	$	1,190		$	2,223		$	2,038		$	1,919		$	1,568		$	2,525		$	559		$	12,742
Loans individually evaluated for impairment	$	-		$	-	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Loans collectively evaluated for impairment		520			200		1,190			2,223			2,038			1,919			1,568			2,525			559			12,742
Total	$	520		$	200	$	1,190		$	2,223		$	2,038		$	1,919		$	1,568		$	2,525		$	559		$	12,742
December 31, 2011
Loans
Loans individually evaluated for impairment	$	2,739		$	-	$	-		$	2,826		$	8,262		$	12,657		$	2,630		$	169		$	89		$	29,372
Loans collectively evaluated for impairment		114,120			16,759		19,602			25,296			8,182			213,326			100,891			40,992			5,560			544,728
Total non-covered loans	$	116,859		$	16,759	$	19,602		$	28,122		$	16,444		$	225,983		$	103,521		$	41,161		$	5,649		$	574,100

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The following tables present a disaggregated analysis of the activity in the allowance for loan losses and loan balances for non-covered loans for the six months ended June 30, 2012 and June 30, 2011.

	One-to-four family residential			Multifamily residential		Construction			Commercial land			Residential development			Other commercial real estate			Consumer real estate			Commercial business			Other consumer			Total
	(Dollars in thousands)
June 30, 2012
Allowance for loan losses
Balance - January 1, 2012	$	500		$	150	$	800		$	2,334		$	1,999		$	1,830		$	1,600		$	2,000		$	500		$	11,713
Charge-offs		(1,374	)		-		-			(90	)		(2,724	)		(2,069	)		(2,489	)		(217	)		(22	)		(8,985	)
Recoveries		68			-		-			119			89			314			59			3			5			657
Provision		1,350			-		(150	)		100			2,650			1,900			2,150			250			100			8,350
Balance - June 30, 2012	$	544		$	150	$	650		$	2,463		$	2,014		$	1,975		$	1,320		$	2,036		$	583		$	11,735
Loans individually evaluated for impairment	$	-		$	-	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Loans collectively evaluated for impairment	$	544		$	150	$	650		$	2,463		$	2,014		$	1,975		$	1,320		$	2,036		$	583		$	11,735
Loans
Loans individually evaluated for impairment	$	4,488		$	-	$	-		$	3,194		$	3,472		$	14,401		$	1,047		$	945		$	18		$	27,565
Loans collectively evaluated for impairment		109,833			17,074		27,114			19,691			6,596			233,874			98,115			42,690			4,946			559,933
Total non-covered loans	$	114,321		$	17,074	$	27,114		$	22,885		$	10,068		$	248,275		$	99,162		$	43,635		$	4,964		$	587,498
June 30, 2011
Allowance for loan losses
Balance - January 1, 2011	$	500		$	200	$	1,000		$	2,163		$	2,000		$	1,561		$	1,500		$	2,500		$	500		$	11,924
Charge-offs		(1,137	)		-		(41	)		(2,244	)		(386	)		(256	)		(91	)		(188	)		(18	)		(4,361	)
Recoveries		7			-		231			-			128			14			9			13			77			479
Provision		1,150			-		-			1,250			1,350			600			150			200			-			4,700
Balance - June 30, 2011	$	520		$	200	$	1,190		$	1,169		$	3,092		$	1,919		$	1,568		$	2,525		$	559		$	12,742
Loans individually evaluated for impairment	$	-		$	-	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Loans collectively evaluated for impairment		520			200		1,190			1,169			3,092			1,919			1,568			2,525			559			12,742
Total	$	520		$	200	$	1,190		$	1,169		$	3,092		$	1,919		$	1,568		$	2,525		$	559		$	12,742
December 31, 2011
Loans
Loans individually evaluated for impairment	$	2,739		$	-	$	-		$	2,826		$	8,262		$	12,657		$	2,630		$	169		$	89		$	29,372
Loans collectively evaluated for impairment		114,120			16,759		19,602			25,296			8,182			213,326			100,891			40,992			5,560			544,728
Total non-covered loans	$	116,859		$	16,759	$	19,602		$	28,122		$	16,444		$	225,983		$	103,521		$	41,161		$	5,649		$	574,100

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Note 9 – FDIC Loss Share Receivable

The following table details changes in the FDIC loss share receivable for the three and six month periods ended June 30, 2012 and June 30, 2011.

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Balance at beginning of period	$	30,448		$	25,611		$	38,931		$	24,848
Additional FDIC loss share receivable from acquisitions		-			19,922			-			19,922
Increase in expected losses on indemnified assets and other changes		5,959			435			6,925			1,749
Claimable net losses on OREO covered under loss share agreements		774			476			1,563			660
Reimbursable expenses claimed		483			242			1,020			367
Accretion of discounts and premiums, net		31			(287	)		(886	)		(1,004	)
Receipt of payments from FDIC		(8,832	)		(2,975	)		(18,690	)		(3,118	)
Balance at end of period	$	28,863		$	43,424		$	28,863		$	43,424

Note 10 – Deposits

Deposit balances and average rates are detailed by category in the following table for the respective periods:

	June 30, 2012					December 31, 2011
	Amount		Average Rate			Amount		Average Rate
	(Dollars in thousands)
Noninterest-bearing demand	$	95,512		0.00	%	$	88,077		0.00	%
Interest-bearing demand		199,867		0.20	%		199,390		0.41	%
Money market deposit		153,775		0.29	%		155,228		0.52	%
Savings accounts		23,945		0.16	%		20,542		0.17	%
Time deposits		379,665		0.97	%		412,819		1.26	%
Total deposits	$	852,764		0.55	%	$	876,056		0.81	%

Note 11 – Preferred Stock

On September 22, 2011, the Company entered into a Securities Purchase Agreement with the Secretary of the United States Department of the Treasury (“Treasury”), pursuant to which the Company issued and sold to the Treasury 20,500 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (“Series C Preferred Stock”), having a liquidation preference of $1,000 per share, for aggregate proceeds of $20,500,000.    The Securities Purchase Agreement was entered into, and the Series C Preferred Stock was issued, pursuant to the Treasury’s Small Business Lending Fund program (“SBLF”), as established under the Small Business Jobs Act of 2010.   The Company’s rights and obligations with respect to the Series C Preferred Stock are set forth in the Securities Purchase Agreement and the Certificate of Designation to its Certificate of Incorporation filed by the Company with the Secretary State of the State of Delaware. The Series C Preferred Stock is entitled to receive non-cumulative dividends payable quarterly.  The dividend rate was initially set at 4.84% per annum based upon the initial level of qualified small business lending (“QSBL”) by the Bank.  The dividend rate for future dividend periods will be set based upon the percentage change in the QSBL between each dividend period and the baseline QSBL level.  This dividend rate may vary from 1% per annum to 5% per annum for the second through tenth dividend periods, from 1% per annum to 7% per annum for the eleventh through the second half of the nineteenth dividend periods.  The current dividend rate is 1.3%.  If the Series C Preferred Stock remains outstanding for more than four-and-one-half years, the dividend rate will be fixed at 9%.  Prior to that time the dividend rate decreases as the level of the Bank’s QSBL increases.  Also, the Company may redeem the shares of Series C Preferred Stock, in whole or in part, at any time subject to prior approval by the Company’s primary federal banking regulator.

22

As a result of the Company’s participation in SBLF, the Company redeemed all 20,500 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, it sold to the Treasury on December 12, 2008, in connection with the Treasury’s Capital Purchase Program.  The Company paid $20.6 million to the Treasury to redeem the Series A Preferred Stock, which includes the original investment of $20.5 million, plus accrued dividends.

Note 12 – Commitments

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 at the respective periods are detailed in the following table.

	June 30, 2012		December 31, 2011
	(Dollars in thousands)
Loan commitments
Residential mortgage loans	$	10,218	$	24,484
Total loan commitments	$	10,218	$	24,484
Unused lines of credit
Residential construction	$	8,260	$	7,390
Commercial real estate		15,738		18,593
Commercial business		10,962		9,558
Consumer		74,525		74,930
Total unused lines of credit	$	109,485	$	110,471
Undisbursed Construction Loan Proceeds	$	795	$	1,200

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Note 13 – Fair Value Measurements

The Company records certain assets at fair value. The Company has not elected the fair value option for liabilities.  Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets, to perform impairment assessments, and for disclosure purposes.  The Company uses quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:

Level 1 — The valuation is based on quoted prices in active markets for identical instruments.

Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument.  Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Investment securities available for sale and rabbi trusts are recorded at fair value on a recurring basis.  Additionally, the Company records at fair value other assets on a nonrecurring basis, including presold loans in process of settlement, 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.

Fair value measurements for assets 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 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 following is a description of valuation methodologies used for assets recorded at fair value. The determination of where an instrument falls in the hierarchy requires significant judgment.

Financial Instruments on a Recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:

Investment Securities – 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.  These Level 2 securities are valued using an independent third party.  This independent third party uses multiple pricing vendors and matrix pricing methods developed in accordance with the Securities Industry and Financial Markets Association’s industry-standard methods.  Level 3 investment securities 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.

24

The table below presents by level, the amount of assets at June 30, 2012 and December 31, 2011 measured at fair value on a recurring basis:

	Fair Value Measurement Classification
	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
June 30, 2012
Investment Securities Available for Sale
Municipal bonds	$	-	$	1,478	$	200	$	1,678
Mortgage-backed bonds		-		15,055		-		15,055
Equity securities		-		-		1,625		1,625
Total	$	-	$	16,533	$	1,825	$	18,358
December 31, 2011
Investment Securities Available for Sale
U.S. Government Agency obligations	$	-	$	7,241	$	-	$	7,241
Municipal bonds		-		6,511		200		6,711
Mortgage-backed bonds		-		35,492		-		35,492
SBA securities		-		1,326		-		1,326
Equity securities		-		-		1,366		1,366
Total	$	-	$	50,570	$	1,566	$	52,136

The following table provides a reconciliation of the beginning and ending balances for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the six months ended June 30, 2012 and June 30, 2011.

	Six Months Ended June 30,
	2012		2011
	(Dollars in thousands)
Beginning balance, January 1	$	1,566	$	3,023
Total gains included in:
Other comprehensive income		47		45
Purchases		212		-
Sales		-		(1,065	)
Transfers in		-		258
Ending balance, June 30	$	1,825	$	2,261

The purchases in 2012 represent capital calls for two Small Business Investment Company investments. The sales in 2011 represent the sale of corporate bonds that were not traded on an active exchange and the incoming transfers in 2011 include equity securities that were obtained as partial payment on a loan that had defaulted.

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Financial Instruments on a Non-recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a non-recurring basis:

Investment Securities – Investment securities held to maturity are recorded at amortized cost.  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.  These Level 2 securities are valued using an independent third party.  This independent third party uses multiple pricing vendors and matrix pricing methods developed in accordance with the Securities Industry and Financial Markets Association’s industry-standard methods.  Level 3 investment securities 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.

Presold Loans in Process of Settlement - The Company does not record all loans at fair value on a recurring basis.  However, loans that have been presold and are in the process of settlement are recorded at their fair value.  These presold loans are recorded as nonrecurring Level 2 since there is a firm commitment by a qualified third party to purchase the loans within a 90 day period.

Impaired Loans - 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 to be impaired. Once a loan is identified as being impaired, management measures the impairment in accordance with ASC 310-10-35. The fair value of impaired loans is estimated using one of several methods, including collateral value, market price and discounted cash flows. When the fair value of the collateral was based on an observable market price, the Company recorded the impaired loan as nonrecurring Level 2. When an observable market price was not available or when management made assumptions that impact the fair value of the collateral, such as estimated disposition or holding costs, the Company recorded the impaired loan as nonrecurring Level 3. Management has determined that the fair value of the Company’s impaired loans used Level 3 methodology.  For substantially all of the Company’s impaired loans as of June 30, 2012 and December 31, 2011, the valuation methodology utilized by the Company was collateral based measurements such as a real estate appraisal and the discount to reflect current market conditions and ultimately collectability ranged from 0% to 30% for each of the respective periods.

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, the Company records the foreclosed asset as nonrecurring Level 2. When an observable market price is not available, or when management makes assumptions that impact the fair value of the collateral, such as estimated disposition or holding costs, the Company records the other real estate owned as nonrecurring Level 3. For substantially all of the Company’s foreclosed assets as of June 30, 2012 and December 31, 2011, the valuation methodology utilized by the Company was collateral based measurements such as a real estate appraisal and the discount to reflect current market conditions ranged from 0% to 30% for each of the respective periods.

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The table below presents the information about certain assets at June 30, 2012 and December 31, 2011 measured at fair value on a non-recurring basis:

	Fair Value Measurement Classification
	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
June 30, 2012
Investment Securities Held to Maturity:
U.S. Treasury obligations	$	10,019	$	-	$	-	$	10,019
U.S. Government Agency obligations		-		14,055		-		14,055
Municipal bonds		-		3,363		-		3,363
Mortgage-backed bonds		-		48,491		-		48,491
SBA securities		-		5,105		-		5,105
Corporate bonds		-		3,814		-		3,814
Presold loans in process of settlement		-		2,146		-		2,146
Impaired loans		-		-		27,565		27,565
Other real estate owned		-		-		21,405		21,405
Total	$	10,019	$	76,974	$	48,970	$	135,963
December 31, 2011
Investment Securities Held to Maturity:
U.S. Treasury obligations	$	10,033	$	-	$	-	$	10,033
U.S. Government Agency obligations		-		26,059		-		26,059
Municipal bonds		-		3,399		-		3,399
Mortgage-backed bonds		-		54,779		-		54,779
Corporate bonds		-		3,845		-		3,845
Presold loans in process of settlement		-		2,146		-		2,146
Impaired loans		-		-		29,372		29,372
Other real estate owned		-		-		17,571		17,571
Total	$	10,033	$	90,228	$	46,943	$	147,204

Note 14 - Fair Value of Financial Instruments

Fair values of financial instruments have been estimated by the Company using the provisions of ASC Topic 825, Financial Instruments “ASC 825”, which requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments.  ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.  The following methods and assumptions were used to estimate the fair value of financial instruments:

Cash and due from banks - The carrying amounts reported in the balance sheets for cash and noninterest-bearing deposits approximate the fair value of those assets.

Interest bearing deposits - The carrying amounts reported in the balance sheets for interest bearing deposits approximate the fair value of those assets.

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Investment securities - Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on readily available pricing sources for market transactions involving comparable types of investments in active markets.

Federal Home Loan Bank stock - The fair values for FHLB stock are its carrying value since this is the amount for which it could be redeemed. There is no active market for this stock and the Company, in order to be a member of the FHLB, is required to maintain a minimum investment in the FHLB.

Presold loans in process of settlement – The fair values of presold loans in process of settlement are its carrying value since these loans have a firm commitment to be purchased by an independent third party.

Loans, net - The fair values for fixed rate loans are estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms and credit ratings for the same remaining maturities. The fair values of variable rate loans that reprice frequently are based on its carrying value.  The resulting fair values for fixed and variable rate loans are adjusted for the allowance for loan losses.

FDIC loss share receivable - The fair values for the FDIC indemnification asset are estimated based on discounted future cash flows using current discount rates.

Accrued interest receivable and Accrued interest payable - The carrying values of accrued interest receivable and accrued interest payable are assumed to approximate fair value.

Bank-owned life insurance - The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer.

Demand deposits, money market accounts and savings accounts - The fair values of demand deposits, money market accounts and savings accounts are equal to the amount payable on demand at the reporting date.

Time deposits – The fair values for time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on these accounts to a schedule of aggregated expected monthly maturities on time deposits.

Securities sold under repurchase agreements - The fair values of securities sold under repurchase agreements are equal to the carrying value due to the short-term nature of these instruments.

Borrowed Money - The fair values for borrowed money are estimated based on discounted future cash flows using current discount rates for similar borrowings.

Subordinated debt - The fair value for subordinated debt is estimated based on a broker indication of fair value at the respective dates.

At June 30, 2012 and December 31, 2011, 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, 2012 and December 31, 2011, the carrying amounts and fair values of these off-balance sheet financial instruments were considered immaterial.

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The carrying amounts and estimated fair valuesof financial instruments at the respective dates were as follows:

	June 30, 2012				December 31, 2011
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(Dollars in thousands)
Financial assets
Cash and due from banks	$	11,839	$	11,839	$	13,296	$	13,296
Interest bearing deposits		116,985		116,985		75,048		75,048
Investment securities		100,634		103,205		147,899		150,251
Federal Home Loan Bank stock		4,443		4,443		5,067		5,067
Presold loans in process of settlement		2,146		2,146		2,146		2,146
Loans, net		704,637		714,077		722,075		735,685
FDIC loss share receivable		28,863		28,863		38,931		38,931
Accrued interest receivable		1,840		1,840		2,773		2,773
Bank-owned life insurance		18,723		18,723		18,978		18,978
Financial liabilities
Demand deposits	$	295,379	$	295,379	$	287,466	$	287,466
Money market accounts		153,775		153,775		155,229		155,229
Savings accounts		23,945		23,945		20,542		20,542
Time deposits		379,665		381,475		412,819		415,145
Securities sold under repurchase agreements		7,554		7,554		9,787		9,787
Borrowed money		76,706		85,089		78,688		87,697
Subordinated debt		15,464		7,732		15,464		7,732
Accrued interest payable		695		695		981		981

Note 15 – Subsequent Events

The Company has evaluated subsequent events for accounting and disclosure purposes through the date the financial statements are issued.

Dividend Declaration.  On July 23, 2012, the Board of Directors of the Company approved and declared a regular cash dividend of one cent ($0.01) per share of common stock to shareholders of record as of August 6, 2012, payable on August 20, 2012. The Company has paid cash dividends in each of the 57 quarters since the Company’s conversion to public ownership.

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

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the Company’s financial condition, results of operations and business of the Company and the Bank.  These statements are based on assumptions and estimates 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.  Such forward- looking statements can be identified by the use of words such as  “may,” “would,” “could,” “will,” “expect,” “believe,” “estimate,” “intend,” and “plan,” as well as similar expressions. Such 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.  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, 1) the timing and amount of revenues that may be recognized by the Company, 2) changes in local or national economic trends, 3) increased competition among depository and financial institutions, 4) continuation of current revenue and expense trends (including trends affecting charge-offs and provisions for loan losses), 5) changes in interest rates and the shape of the yield curve, 6) our ability to continue to expand our small business lending and thereby maintain the dividend rate on our SBLF preferred stock, and 7) adverse legal, regulatory or accounting changes and other risk factors described under Item 1A. “Risk Factors” of the Company’s 2011 Annual Report on Form 10-K and other filings made with the Securities and Exchange Commission.  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.

Non-GAAP Financial Measures

This quarterly report contains certain non-GAAP financial measures and should be read along with the accompanying tables which provide a reconciliation of non-GAAP measures to GAAP measures.  Management believes that these non-GAAP measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods.  Non-GAAP measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under accounting principles generally accepted in the United States (“GAAP”), and investors should consider the company’s performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the company.   Non-GAAP measures have limitations as analytical tools, and investors should not consider them in isolation, or as a substitute for analysis of the Company’s results or financial condition as reported under GAAP.

Executive Summary

Citizens South Banking Corporation (the “Company”) is a Delaware corporation that owns all of the outstanding shares of common stock of Citizens South Bank (the "Bank"). The shares of common stock of the Company trade on the Nasdaq Global Market under the ticker symbol “CSBC.”  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 Company became the holding company for the Bank on September 30, 2002, in connection with the mutual-to-stock conversion of Citizens South Holdings, MHC, the mutual holding company of Citizens South Banking Corporation, a federal corporation, formerly named Gaston Federal Bancorp, Inc., which was originally formed on March 18, 1998, for the purpose of acting as the holding company for the Bank.

Citizens South Bank was chartered in 1904 and currently operates as a federally chartered savings bank. The Bank is headquartered in Gastonia, North Carolina, which is located approximately 20 miles west of Charlotte, North Carolina.  The Bank’s executive office is located at 519 South New Hope Road, P.O. Box 2249, Gastonia, North Carolina 28053-2249 and its telephone number is (704) 868-5200. The Company also maintains a website at www.citizenssouth.com that includes important information on our Bank, including a list of our products and services, branch locations and current financial information.  Information on our website should not be considered a part of this interim report.

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The Bank provides a full range of retail products, commercial banking services, and mortgage lending services to local customers through our 21 branch offices located in North Carolina, South Carolina, and Georgia.  Our primary banking activities include the acceptance of deposits and the origination of loans.  We offer retail deposit products such as checking, savings, and money market accounts, as well as time deposits and individual retirement accounts.  For business customers, the Bank offers commercial analysis deposit accounts, business checking accounts, and repurchase agreements (also called securities sold under agreement to repurchase).  The Bank is a member of the Certificate of Deposit Account Registry Service (“CDARS”), which gives our customers the ability to obtain FDIC insurance on deposits of up to $50 million, while continuing to work directly with our Bank. The Bank also offers a wide variety of consumer and commercial loans including business loans, real estate loans, residential loans and consumer loans.  We offer consumer and business credit cards, debit cards, commercial letters of credit, safe deposit box rentals, and electronic funds transfer services, including automated clearing house, or ACH, and wire transfers.  In addition, the Bank offers online banking, remote deposit capture, cash management, bank-by-phone capabilities, and ATM services.   The Bank also acts as a broker in the sale of uninsured financial products.

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, 2012 and 2011.  Financial highlights for the five previous quarters are presented in the following tables.

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Quarterly Financial Highlights (unaudited)	At and For the Quarters Ended
	2012						2011
	June 30			March 31			December 31			September 30			June 30
(Dollars in thousands, except share and per share data)
Summary of Operations:
Interest income - taxable equivalent	$	10,098		$	10,528		$	11,089		$	11,308		$	11,488
Interest expense		1,888			2,016			2,304			2,554			2,826
Net interest income - taxable equivalent		8,210			8,512			8,785			8,754			8,662
Less: Taxable-equivalent adjustment		47			59			65			62			69
Net interest income		8,163			8,453			8,720			8,692			8,593
Provision for loan losses		2,555			6,300			4,635			1,350			1,700
Net interest income after loan loss provision		5,608			2,153			4,085			7,342			6,893
Noninterest income		2,700			2,719			1,985			1,990			5,886
Noninterest expense		9,532			8,684			8,779			8,931			9,270
Net income (loss) before income taxes		(1,224	)		(3,812	)		(2,709	)		401			3,509
Income tax expense (benefit)		(576	)		(1,672	)		(1,172	)		28			1,213
Net income (loss)		(648	)		(2,140	)		(1,537	)		373			2,296
Dividends and accretion of discount on preferred stock		68			122			767			247			256
Net income (loss) allocable to common shareholders	$	(716	)	$	(2,262	)	$	(2,304	)	$	126		$	2,040
Per Common Share Data:
Net income (loss):
Basic	$	(0.06	)	$	(0.20	)	$	(0.20	)	$	0.01		$	0.18
Diluted		(0.06	)		(0.20	)		(0.20	)		0.01			0.18
Weighted average shares outstanding:
Basic		11,463,396			11,469,525			11,470,599			11,462,107			11,455,642
Diluted		11,463,396			11,469,525			11,470,599			11,462,107			11,455,642
End of period shares outstanding		11,506,324			11,506,324			11,506,324			11,506,324			11,506,324
Cash dividends declared	$	0.01		$	0.01		$	0.01		$	0.01		$	0.01
Book value		5.99			6.04			6.27			6.44			6.44
Tangible book value		5.90			5.93			6.15			6.31			6.29
Selected Financial Performance Ratios (annualized):
Return on average assets		(0.27	)%		(0.85	)%		(0.85	)%		0.05	%		0.73	%
Return on average common equity		(4.17	)%		(12.86	)%		(12.45	)%		0.68	%		11.00	%
Noninterest income to average total assets		1.03	%		1.02	%		0.73	%		0.72	%		2.12	%
Noninterest expense to average total assets		3.62	%		3.25	%		3.24	%		3.23	%		3.34	%
Efficiency ratio		87.75	%		77.73	%		82.01	%		83.61	%		64.02	%
Operating Earnings (Non-GAAP):
Net income (loss) allocable to common shareholders	$	(716	)	$	(2,262	)	$	(2,304	)	$	126		$	2,040
(Gain) loss on acquisition, net of tax		106			-			(15	)		29			(2,695	)
Gain on sale of investments, net of tax		-			(405	)		-			(67	)		-
Other-than-temporary impairment on securities, net of tax		-			-			22			-			-
Acquisition and integration expenses, net of tax		-			-			584			86			345
Net operating income (loss)	$	(610	)	$	(2,667	)	$	(1,713	)	$	174		$	(310	)
Operating net income (loss) per common share:
Basic	$	(0.05	)	$	(0.23	)	$	(0.15	)	$	0.02		$	(0.03	)
Diluted		(0.05	)		(0.23	)		(0.15	)		0.02			(0.03	)
Pre-tax, pre-credit earnings  (1)	$	3,612		$	3,543		$	3,545		$	3,545		$	3,902
Operating return on average assets		(0.23	)%		(1.00	)%		(0.63	)%		0.06	%		(0.11	)%
Operating return on average equity		(3.55	)%		(11.72	)%		(7.29	)%		0.73	%		(1.30	)%
Operating efficiency ratio  (2)		66.68	%		68.13	%		69.52	%		67.52	%		65.92	%

(1)	Calculated using net interest income plus noninterest income less noninterest expense adjusted for the following items: 1) gains or losses from acquisition or sale of investments or sale of other assets; 2) other-than-temporary impairment on securities; 3) amortization of intangible assets; 4) other real estate owned valuation adjustments and expenses; and 5) acquisition and integration expenses.
(2)	Calculated by dividing noninterest expense by net interest income plus noninterest income excluding the following items: 1) gains or losses from acquisition or sale of investments; 2) other-than-temporary impairment on securities; 3) other real estate owned valuation adjustments and expenses; and 4) acquisition and integration expenses.

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Quarterly Financial Highlights (unaudited)	At and For the Quarters Ended
	2012						2011
	June 30			March 31			December 31			September 30			June 30
(Dollars in thousands, except per share data)
Credit Quality Information and Ratios:
Allowance for loan losses - beginning of period	$	11,583		$	11,713		$	12,956		$	12,742		$	12,006
Add:  Provision for loan losses		2,555			6,300			4,635			1,350			1,700
Less:  Net charge-offs		2,403			6,430			5,878			1,136			964
Allowance for loan losses - end of period	$	11,735		$	11,583		$	11,713		$	12,956		$	12,742
Assets not covered by FDIC loss-share agreements:
Past due loans (30-89 days) accruing	$	1,812		$	5,362		$	4,933		$	4,479		$	5,687
Past due loans (30-89 days) to total non-covered loans		0.31	%		0.92	%		0.86	%		0.77	%		0.99	%
Nonperforming non-covered loans:
One-to-four family residential	$	4,230		$	2,698		$	2,407		$	1,556		$	1,406
Construction		-			-			-			-			-
Commercial land		3,169			3,852			2,631			3,176			3,167
Residential development		3,000			3,742			6,474			6,459			5,155
Other commercial real estate		8,489			8,924			4,173			6,602			10,306
Commercial business		945			1,086			168			306			201
Consumer		976			1,750			2,958			2,426			2,440
Total nonperforming non-covered loans		20,809			22,052			18,811			20,525			22,675
Other nonperforming non-covered assets		11,504			11,987			8,936			8,208			10,723
Total nonperforming non-covered assets	$	32,313		$	34,039		$	27,747		$	28,733		$	33,398
Allowance for loan losses to total non-covered loans		2.00	%		2.00	%		2.04	%		2.23	%		2.22	%
Net charge-offs to average non-covered loans (annualized)		1.65	%		4.44	%		4.07	%		0.79	%		0.66	%
Nonperforming non-covered loans to non-covered loans		3.54	%		3.80	%		3.28	%		3.53	%		3.95	%
Nonperforming non-covered assets to total assets		3.08	%		3.17	%		2.57	%		2.61	%		2.99	%
Nonperforming non-covered assets to total non-covered loans and other real estate owned		5.39	%		5.75	%		4.76	%		4.87	%		5.72	%
Assets covered by FDIC loss-share agreements:
Past due loans (30-89 days) accruing (3)	$	1,495		$	2,726		$	5,372		$	6,430		$	12,987
Past due loans (30-89 days) to total covered loans		1.16	%		1.83	%		3.36	%		3.81	%		7.34	%
Total covered nonperforming loans (4)	$	36,460		$	40,582		$	44,056		$	37,074		$	35,830
Other covered nonperforming assets		9,900			9,447			8,746			12,765			14,127
Total covered nonperforming assets	$	46,360		$	50,029		$	52,802		$	49,839		$	49,957
Classified Assets(5)
Non-covered classified loans	$	30,142		$	32,146		$	28,727		$	35,357		$	41,515
OREO and other nonperforming assets		11,504			11,987			8,936			8,208			10,723
Total classified assets	$	41,646		$	44,133		$	37,663		$	43,565		$	52,238
Tier 1 capital	$	100,586		$	100,774		$	102,539		$	104,487		$	105,088
Total classified assets to Tier 1 capital		41.40	%		43.79	%		36.73	%		41.69	%		49.71	%

(3)	The contractual balance of past due loans covered by  FDIC loss-share agreements totaled $13.7 million, $8.2 million, $7.0 million, $3.5 million and $1.9 million at June 30, 2011, September 30, 2011, December 31, 2011, March 31, 2012, and June 30, 2012, respectively.
(4)	The contractual balance of nonperforming loans covered by  FDIC loss-share agreements totaled $39.3 million $48.8 million, $55.4 million, $46.2 million and $41.4 million at June 30, 2011, September 30, 2011, December 31, 2011, March 31, 2012, and June 30, 2012, respectively.
(5)	Excludes loans and OREO covered by FDIC loss-share agreements.

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Quarterly Financial Highlights (unaudited)	At and For the Quarters Ended
	2012						2011
	June 30			March 31			December 31			September 30			June 30
(Dollars in thousands, except per share data)
Net Interest Margin (annualized):
Yield on earning assets		4.63	%		4.75	%		4.81	%		4.84	%		4.95	%
Cost of funds		0.88	%		0.92	%		1.01	%		1.11	%		1.23	%
Net interest rate spread		3.75	%		3.83	%		3.80	%		3.73	%		3.72	%
Net interest margin (taxable equivalent)		3.78	%		3.88	%		3.84	%		3.76	%		3.78	%
Selected End of Period Balances:
Loans covered by FDIC loss-share agreements	$	128,874		$	148,833		$	159,688		$	168,940		$	177,047
Loans not covered by FDIC loss-share agreements		587,498			579,692			574,100			582,065			573,603
Total loans, net		716,372			728,525			733,788			751,005			750,650
Investment securities		100,635			121,411			147,899			132,443			156,328
Total interest-earning assets		872,256			890,456			895,003			913,910			927,463
Total assets		1,049,177			1,073,815			1,080,460			1,098,974			1,117,993
Noninterest-bearing deposits		95,512			97,437			88,077			87,413			82,305
Interest-bearing deposits		757,252			775,209			787,979			801,167			822,273
Total deposits		852,764			872,646			876,056			888,580			904,578
Total borrowings and other debt		99,724			104,080			103,939			105,778			108,011
Shareholders' equity		89,473			90,010			92,659			94,782			94,771
Selected Quarterly Average Balances:
Loans covered by FDIC loss-share agreements	$	136,530		$	154,344		$	164,314		$	173,755		$	170,580
Loans not covered by FDIC loss-share agreements		582,263			579,224			578,083			576,846			583,294
Average loans, net		718,793			733,568			742,397			750,601			753,874
Investment securities		109,559			128,086			140,846			146,017			157,513
Average interest-earning assets		872,028			880,073			906,064			920,932			918,118
Average total assets		1,053,263			1,069,651			1,084,313			1,107,687			1,110,740
Noninterest-bearing deposits		93,126			90,024			87,770			84,001			81,617
Interest-bearing deposits		763,442			777,621			789,233			810,469			814,736
Average total deposits		856,568			867,645			877,003			894,470			896,353
Average borrowings and other debt		102,179			103,181			105,872			106,696			107,872
Shareholders' equity		89,472			91,057			94,028			94,711			95,116
Capital Ratios:
Total equity to total assets		8.53	%		8.38	%		8.58	%		8.62	%		8.48	%
Tangible common equity to tangible assets		6.47	%		6.36	%		6.56	%		6.61	%		6.49	%
Total Risk-Based Capital (Bank only)		15.59	%		15.50	%		15.60	%		17.32	%		17.29	%
Tier 1 Risk-Based Capital (Bank only)		14.33	%		14.25	%		14.35	%		16.06	%		16.03	%
Tier 1 Leverage Capital (Bank only)		9.62	%		9.42	%		9.44	%		9.53	%		9.42	%

34

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 (“GAAP”) and conform to general practices in the banking industry.  We consider accounting policies that require difficult or subjective 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 Company’s portfolio at the measurement date.  Management’s determination of the adequacy of the allowance is based on periodic 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 consistently applied, 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.  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.  Specific allowances or principal write-downs 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.  We increase our allowance for loan losses by charging provisions for loan losses against our current period income.  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 (“OTTI”).The Company reviews all investment securities with significant declines in fair value for potential OTTI on at least a quarterly basis. Consideration is given to the amount of time that the impairment has existed, the financial condition of the issuer and the probability of receiving the required payments on the investments.  Also, the Company’s intent and ability to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value or for a debt security whether it is more-likely-than-not that the Company will be required to sell the debt security prior to recovering its fair value is considered.  The Company records an impairment charge when it believes an investment has experienced a decline in value that is OTTI.  Generally changes in market interest rates that result in a decline in value of an investment security are considered to be temporary, since the value of such investment can recover in the foreseeable future as market interest rates return to their original levels.  Management believes this is a critical accounting policy because this evaluation of the underlying credit or analysis of other conditions contributing to the decline in value involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

Fair Value of Acquired Loans.The initial fair value of loans acquired in FDIC-assisted acquisitions and the related FDIC loss-share receivable involved a high degree of judgment and complexity.  On March 19, 2010, the Bank acquired Bank of Hiawassee in an FDIC-assisted acquisition and on April 15, 2011, the Bank acquired New Horizons Bank in an FDIC-assisted transaction.  The carrying value of the acquired loans and the FDIC loss-share receivable reflect management’s best estimate based on information available at the time of the acquisition.  The amount that the Bank actually receives on these loans could differ materially from the carrying value reflected in the financial statements based upon the timing and collections on the acquired loans in the future.  To the extent that actual values realized for the acquired loans are different from the initial estimates, the FDIC loss-share receivable will generally be impacted in an offsetting manner due to the nature of the FDIC loss-share agreements.

35

Comparison of Financial Condition for the Periods Ended June 30, 2012 and December 31, 2011

Assets.  During the first half of 2012 total assets of the Company decreased by $31.3 million, or 2.9%, to $1.0 billion at June 30, 2012, as detailed in the following paragraphs.

Total cash and cash equivalents, which include cash and due from banks and interest bearing deposits, increased by $40.5 million, or 45.8%, from $88.3 million at December 31, 2011, to $128.8 million at June 30, 2012. This increase in cash and cash equivalents was primarily attributable to the sale of $35.5 million of investment securities coupled with the maturity/issuer call of $40.4 million of investment securities.  The Company’s excess liquidity was primarily held in the Bank’s account with the Federal Reserve Bank.

During the six-month period ended June 30, 2012, loans receivable decreased by $17.4 million, or 2.4%, to $716.4 million at June 30, 2012.  This decrease was primarily due to the Company’s continuing efforts to reduce exposures in its commercial land and residential development loans. During the six-month period ended June 30, 2012, the Company’s commercial land and residential development loans decreased by $18.6 million, or 28.0%, to $47.8 million.  The Company remains focused on originating owner-occupied commercial real estate loans, commercial business loans, residential loans, and consumer loans to qualified borrowers.

A majority of the Company’s loans are to borrowers that are located in the Charlotte region.  While the economy in the Charlotte region has generally outperformed most other large metropolitan areas of the country during the ongoing economic slowdown, the economy in the Charlotte region remains sluggish.  However, the Company’s loan production has improved from $58.5 million during the first half of 2011 to $89.2 million during the first half of 2012.  The Company’s expansion into the North Georgia market will allow the Company to geographically diversify its loan portfolio.  Although the North Georgia market has sustained significant decreases in real estate values over the past several years, management believes that when economic conditions normalize, this new market will be able to provide additional loan growth for the Company. While continued economic slowdowns in the local markets that we serve would have a negative impact on the Company’s ability to generate loan growth, management will seek 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 in the current economic environment.

During the six-month period ended June 30, 2012, investment securities decreased by $47.3 million, or 32.0%, to $100.6 million.  The decrease was due to the sale of $35.5 million in investment securities coupled with the maturity/issuer call of $40.4 million of investment securities, the effects of which were partly offset by the purchase of $21.5 million of investment securities.  These purchased securities were primarily U.S. Government Agency bonds and amortizing securities that provide for periodic cash flow that can be reinvested in higher-yielding loans when loan demand. The investments that were sold included similar types of securities.

Other real estate owned, which includes all properties acquired by the Company through foreclosure, totaled $21.4 million at June 30, 2012, compared to $17.6 million at December 31, 2011.   Of the $21.4 million in other real estate owned at June 30, 2012, $9.9 million is covered by FDIC loss-share agreements.  The remaining $11.5 million of non-covered other real estate owned is comprised of $1.3 million of one-to-four family residential dwellings, $9.4 million of undeveloped land and developed residential lots, and $762,000 of commercial real estate.  All foreclosed properties are written down to their estimated fair value (market value less estimated disposition costs) at acquisition and are predominately located in the Bank’s primary lending area.  Properties may be reappraised after acquisition as market conditions change, resulting in additional valuation adjustments which are reflected in current period noninterest expenses.  Management will continue to aggressively market foreclosed properties for a timely disposition.

During the first half of 2012, premises and equipment decreased by $492,000, or 1.9%, to $25.4 million at June 30, 2012.  This decrease was primarily due to normal depreciation which totaled $649,000 during the first half of 2012.

36

During the first half of 2012, the Company’s FDIC loss share receivable decreased from $38.9 million at December 31, 2011, to $28.9 million at June 30, 2012.  This $10.0 million decrease was primarily due to the reimbursement payments that were made by the FDIC to the Bank during the six month period ended June 30, 2012. These reimbursement payments are based on certificates filed by the Bank with the FDIC on a quarterly basis detailing charge-offs and other qualified expenses on covered loans.

Liabilities. Total liabilities decreased by $28.1 million, or 2.8%, from $987.8 million at December 31, 2011, to $959.7 million at June 30, 2012, as detailed in the following paragraphs.

During the first half of 2012, total deposits decreased by $23.3 million, or 2.7%, to $852.8 million at June 30, 2012. The decrease in deposits was primarily due to a $33.2 million, or 8.0%, decline in time deposits. This decrease in time deposits was primarily due to the Company’s continued focus on building customer banking relationships and avoiding growth through offering above-market rates on time deposits.  Excluding the time deposits, total core deposits increased by $9.9 million, or 2.1%, to $473.1 million at June 30, 2012.  This core deposit growth included a $7.4 million, or 8.4%, increase in non-interest bearing demand deposits, a $477,000, or 0.2%, increase in interest-bearing demand deposit accounts and a $3.4 million, or 16.6%, increase in savings accounts which were partly offset by a $1.4 million, or 0.9%, decrease in money market accounts.   We believe our core deposit growth was partly due to a flight to safety as funds moved from weaker financial institutions as well as a continued emphasis on increasing the Company’s retail and business customers through cross-selling opportunities.

During the first half of 2012 borrowed money decreased by $2.0 million, or 2.5%, to $76.7 million at June 30, 2012. The Company plans to use excess liquidity to repay these borrowings as they mature.

Shareholders’ Equity.  Total shareholders’ equity decreased by $3.2 million, or 3.4%, from $92.7 million at December 31, 2011, to $89.5 million at June 30, 2012.  This decrease was primarily due to the net loss of $2.8 million during the six-month period ended June 30, 2012, and the $300,000 other comprehensive loss that was due to the decrease in the fair value of investment securities available for sale during the six-month period ended June 30, 2012.  In addition, during the second quarter of 2012 the Company paid $229,000 in cash dividends on common stock and $190,000 in cash dividends on preferred stock, which also reduced shareholders’ equity.

Comparison of Results of Operations for the Three Months Ended June 30, 2012 and 2011

General.  Net loss allocable to common shareholders for the three months ended June 30, 2012, amounted to $716,000, or $0.06 per diluted share, as compared to net income available to common shareholders of $2.0 million, or $0.18 per diluted share, for the three months ended June 30, 2011.

Net interest income. Net interest income decreased by $430,000, or 5.0%, to $8.2 million for the second quarter of 2012 as compared to $8.6 million for the second quarter of 2011. The Company’s net interest margin remained flat at 3.78% for the quarter ended June 30, 2012, compared to the quarter ended June 30, 2011.

Interest income decreased by $1.4 million, or 12.0%, to $10.1 million for the second quarter of 2012.  This decrease was primarily due to a 32 basis points decrease in the Company’s yield on assets from 4.95% for the quarter ended June 30, 2011, to 4.63% for the quarter ended June 30, 2012.  In addition, average interest-earning assets during the comparable second quarter periods decreased by $46.1 million, or 5.0%, to $872.0 million for the quarter ending June 30, 2012.  The decrease in average interest-earning assets was comprised of a $47.9 million, or 30.4%, decrease in average investment securities to $109.6 million for the second quarter of 2012, and a $43.2 million, or 6.2%, decrease in average accruing loans to $657.4 million for the second quarter of 2012.  Average accruing loans decreased due to higher levels of repayments resulting from lower market interest rates and higher levels of average nonaccrual loans.  The decreases in average investment securities and average accruing loans were partly offset by a $45.1 million, or 75.3%, increase in average interest-earning deposits.

Interest expense decreased by $938,000, or 33.2%, for the comparable quarters to $1.9 million for the second quarter of 2012.  This decrease in interest expense was largely due to lower market interest rates, which resulted in a 35 basis point decrease in the average cost of funds to 0.88% for the quarter ended June 30, 2012.  In addition, during the respective periods, average interest-bearing liabilities decreased by $57.0 million, or 6.2%, to $865.6 million for the second quarter of 2012.  This change included a $51.3 million, or 6.3%, decrease in average interest-bearing deposits and a $5.7 million, or 5.3%, decrease in average borrowings.  The decrease in average interest-bearing deposits was largely due to the maturities and subsequent repayment of time deposits, while the decrease in average borrowings was due to normal maturities during the period.

37

Provision for loan losses.  The Company’s provision for loan losses increased from $1.7 million for the second quarter of 2011 to $2.6 million for the second quarter of 2012.  The increase in the provision for loan losses was largely due to the higher level of net charge-offs which totaled $2.4 million, or 1.7% of average non-covered loans annualized, during the second quarter of 2012 compared to $964,000, or 0.7% of average non-covered loans annualized, during the second quarter of 2011.  The Company’s ratio of nonperforming non-covered assets to total assets increased slightly to 3.08% at June 30, 2012, compared to 2.99% at June 30, 2011.

Noninterest income.  Noninterest income decreased by $3.2 million to $2.7 million for the three months ended June 30, 2012, as compared to $5.9 million for the three months ended June 30, 2011. The primary reason for the decrease was a $4.6 million decrease in the gain from acquisition.  The following table presents the detail for the three-month periods ending June 30, 2012 and June 30, 2011.

	Three Months Ended June 30,
	2012			2011			Variance
	(Dollars in thousands)
Noninterest income
Service charges on deposit accounts	$	1,092		$	1,046		$	46
Mortgage banking income		393			254			139
Commissions on sales of financial products		67			69			(2	)
Income from bank-owned life insurance		184			214			(45	)
Gain (loss) from acquisition		(175	)		4,418			(4,593	)
Gain on sale of investments, available for sale		-			1			(1	)
Gain (loss) on sale of other assets		85			(338	)		423
Other		1,054			222			847
Total noninterest income	$	2,700		$	5,886		$	(3,186	)

Service charges on deposit accounts were higher because of the increased number of demand deposit accounts, due in part to the acquisition of New Horizons Bank in April 2011, which generate monthly service charges and non-sufficient fund fees on overdrafts.  Mortgage banking income was higher in the second quarter of 2012 due to increased origination activity resulting largely from lower mortgage loan interest rates.  Commissions on sales of financial products were flat during the respective quarters. Income from bank-owned life insurance declined due to lower market interest rates. The gain from acquisition in the second quarter of 2011 represents the initial gain that was booked in conjunction with the acquisition of New Horizons Bank, while the loss from acquisition in the second quarter of 2012 represented adjustments to that initial gain.  Adjustments to the initial gain may be made over a 12 month period as new information impacting the Company’s initial fair value estimates are received.  No additional adjustments to the gain on acquisition are expected. The gain (loss) on sale of other assets was higher due to the recognition of gains from the sale of other real estate owned during the second quarter of 2012.  Other income increased primarily due to OREO acquisitions that were valued in excess of the outstanding loan balance at the time of acquisition and an increase in the indemnification asset discount accretion during the quarter.

38

Noninterest expense. Noninterest expense increased by $262,000, or 2.8%, to $9.5 million for the quarter ended June 30, 2012.  The following table presents the detail of noninterest expense for the three-month periods ended June 30, 2012 and June 30, 2011.

	Three Months Ended June 30,
	2012			2011		Variance
	(Dollars in thousands)
Noninterest Expense
Compensation and benefits	$	3,902		$	3,806	$	96
Occupancy and equipment		898			873		25
Data processing and other technology		235			296		(61	)
Professional services		308			249		59
Advertising and business development		74			71		3
Loan collection and other expenses		864			204		660
Deposit insurance		(49	)		361		(410	)
Amortization of intangible assets		109			136		(27	)
Office supplies		53			62		(9	)
Telephone and communications		107			111		(4	)
Other real estate owned valuation adjustments		1,784			1,476		308
Other real estate owned expenses		388			596		(208	)
Acquisition and integration expenses		-			566		(566	)
Other		859			463		396
Total noninterest expense	$	9,532		$	9,270	$	262

Compensation and benefits increased due to the employees that were added as a part of the New Horizons Bank acquisition in April 2011.  Occupancy and equipment expense increased in part due to the addition of one full service office as a result of the aforementioned acquisition. Data processing and other technology decreased since the Company was operating on two separate computer systems during the second quarter of 2011 as a result of the acquisition.  These computer systems were integrated in third quarter of 2011, resulting in lower data processing costs during the second quarter of 2012.  Professional services increased due to higher consulting fees incurred during the second quarter of 2012 as compared to the second quarter of 2011.  Advertising and business development costs were flat during the respective periods.  Loan collection and other expenses increased due to higher FDIC-covered expenses during the second quarter of 2012 compared to the second quarter of 2011.  Deposit insurance was lower due to adjustments relating to excess deposit insurance expense that had been taken relating to the two FDIC-assisted acquisitions. Amortization of intangible assets was slightly lower due to the reduced amortization expense related to the core deposit intangible that was created as a result of previous acquisitions.  This intangible asset is being amortized over an eight-year period using the accelerated method, resulting in a progressively decreasing expense over the amortization period.  Office supplies and telephone and communications expenses were relatively unchanged during the respective quarters.  Other real estate owned valuation adjustments increased due to a decline in local real estate values for commercial land and residential development properties during the past year.  Other real estate owned expenses decreased due to fewer real estate tax bills and other expenses relating to these foreclosed properties.  Acquisition and integration expenses decreased since there were no acquisition or integration-related expenses during the second quarter of 2012. Other expenses increased primarily as a result of higher deposit servicing expenses, stock-related expenses and other various miscellaneous items.

Income taxes. The Company recognized an income tax benefit of $576,000 for the quarter ended June 30, 2012, compared to an income tax expense of $1.2 million for the quarter ended June 30, 2011.  The decrease in the income tax expense was due to the pre-tax loss in the second quarter of 2012 compared to the pre-tax income in the second quarter of 2011.

39

Comparison of Results of Operations for the Six Months Ended June 30, 2012 and 2011

General.  Net loss allocable to common shareholders for the six months ended June 30, 2012, amounted to $3.0 million, or $0.26 per diluted share, as compared to net income available to common shareholders of $893,000, or $0.08 per diluted share, for the six months ended June 30, 2011.

Net interest income. Net interest income increased by $490,000, or 3.0%, to $16.6 million for the first half of 2012 as compared to $16.1 million for the first half of 2011. The Company’s net interest margin increased by 22 basis points to 3.83% for the six months ended June 30, 2012, compared to 3.61% for the six months ended June 30, 2011.  This increase in the net interest margin was the result of a 37 basis point decrease in the cost of funds which was partly offset by a 10 basis point decrease in the yield on assets.

Interest income decreased by $1.3 million, or 5.9%, to $20.5 million for the first half of 2012.  This decrease was primarily due to a 10 basis points decrease in the Company’s yield on assets from 4.79% for the six months ended June 30, 2011, to 4.69% for the six months ended June 30, 2012.  In addition, average interest-earning assets during the comparable six month periods decreased by $33.9 million, or 3.7%, to $876.1 million for the six months ending June 30, 2012.  This decrease was comprised of a $27.8 million, or 18.9% decrease in average investment securities to $118.8 million and a $27.1 million, or 3.9%, decrease in average accruing loans to $663.0 million. These decreases during the comparable six-month periods were partly offset by a $20.8 million, or 28.4%, increase in average interest-earning deposits to $94.2 million for the first half of 2012.  Average accruing loans decreased due to higher levels of repayments resulting from lower market interest rates and higher levels of average nonaccrual loans during the comparable periods.  Average investments decreased due to normal maturities and issuer calls which were invested in interest-earning deposits.

Interest expense decreased by $1.8 million, or 31.3%, for the comparable quarters to $3.9 million for the first half of 2012.  This decrease in interest expense was largely due to lower market interest rates, which resulted in a 37 basis point decrease in the average cost of funds to 0.90% for the six months ended June 30, 2012.  In addition, average interest-bearing liabilities decreased by $27.4 million, or 3.0%, to $873.2 million for the first half of 2012.  This change included a $21.4 million, or 2.7%, decrease in average interest-bearing deposits and a $5.9 million, or 5.5%, decrease in average borrowings.  The decrease in average interest-bearing deposits was largely due to the maturity of time deposits that were not renewed and the decrease in average borrowings was due to normal maturities during the period.

Provision for loan losses.  The Company’s provision for loan losses increased from $4.7 million for the first half of 2011 to $8.9 million for the first half of 2012.  The increase in the provision for loan losses was largely due to the higher level of net charge-offs which totaled $8.8 million, or 3.0% of average non-covered loans annualized, during the first half of 2012 compared to $3.9 million, or 1.3% of average non-covered loans annualized, during the first half of 2011. Also, the provision for losses on acquired loans totaled $505,000 for the six months ended June 30, 2012, compared to $0 for the six months ended June 30, 2011. The Company’s ratio of nonperforming non-covered assets to total assets increased slightly to 3.08% at June 30, 2012, compared to 2.99% at June 30, 2011.

Noninterest income.  Noninterest income decreased by $1.9 million to $5.4 million for the six months ended June 30, 2012, as compared to $7.4 million for the six months ended June 30, 2011. The primary reason for the decrease was a $4.3 million decrease in the gain from acquisition from the first half of 2011 compared to the first half of 2012.  The following table presents the detail for the six-month periods ending June 30, 2012 and June 30, 2011.

40

	Six Months Ended June 30,
	2012			2011			Variance
	(Dollars in thousands)
Noninterest income
Service charges on deposit accounts	$	2,147		$	2,004		$	143
Mortgage banking income		710			491			219
Commissions on sales of financial products		153			136			17
Income from bank-owned life insurance		368			397			(59	)
Gain (loss) from acquisition		(175	)		4,163			(4,338	)
Gain on sale of investments, available for sale		664			1			663
Loss on sale of other assets		(53	)		(326	)		273
Other		1,608			500			1,138
Total noninterest income	$	5,422		$	7,366		$	(1,944	)

Service charges on deposit accounts were higher due to the increased number of demand deposit accounts, due in part to the acquisition of New Horizons Bank in April 2011, which generate monthly service charges and non-sufficient fund fees on overdrafts.  Mortgage banking income was higher in the first half of 2012 due to increased origination activity resulting largely from lower mortgage loan interest rates.  Commissions on sales of financial products were slightly higher in 2012 due to increased transactions during the period.  Income from bank-owned life insurance was lower during the respective six month periods due to lower market interest rates. The gain from acquisition in the first half of 2011 represents the initial gain that was booked in conjunction with the acquisition of New Horizons Bank, while the loss from acquisition in the first half of 2012 represented adjustments to that initial gain.  No additional adjustments to the gain on acquisition are expected. The gain on sale of investments was higher during the first half of 2012, due to the fact that there were a fewer number of investments sold during the first half of 2011.  The loss on sale of other assets was lower due to the recognition of some larger gains from the sale of other real estate owned during the first half of 2012 which partly offset losses from the sale of other real estate owned during the period. Other income increased primarily due to the receipt of life insurance proceeds relating to the death of a former director and higher accretion of the discount on FDIC loss share receivable.

Noninterest expense. Noninterest expense increased by $1.3 million, or 7.5%, to $18.2 million for the six months ended June 30, 2012.  The following table presents the detail of noninterest expense for the six-month periods ending June 30, 2012 and June 30, 2011.

41

	Six Months Ended June 30,
	2012		2011		Variance
	(Dollars in thousands)
Noninterest Expense
Compensation and benefits	$	7,748	$	7,454	$	294
Occupancy and equipment		1,806		1,701		105
Data processing and other technology		491		530		(39	)
Professional services		583		502		81
Advertising and business development		142		125		17
Loan collection and other expenses		1,116		494		622
Deposit insurance		369		695		(326	)
Amortization of intangible assets		231		275		(44	)
Office supplies		112		132		(20	)
Telephone and communications		213		207		6
Other real estate owned valuation adjustments		2,784		1,984		800
Other real estate owned expenses		858		597		261
Acquisition and integration expenses		-		611		(611	)
Other		1,767		1,638		129
Total noninterest expense	$	18,220	$	16,945	$	1,275

Compensation and benefits increased due to the employees that were added as a part of the New Horizons Bank acquisition in April 2011.  Occupancy and equipment expense increased in part due to the addition of one full service office as a result of the aforementioned acquisition. Data processing and other technology decreased since the Company was operating on two separate computer systems during the first half of 2011 as a result of the acquisition.  These computer systems were integrated in third quarter of 2011, resulting in lower data processing costs during the first half of 2012. Professional services increased due to higher consulting fees incurred during the first half of 2012 as compared to the first half of 2011.  Advertising and business development increased due to costs related to operating in a new market as a result of the New Horizons Bank acquisition.  Loan collection and other expenses increased due to higher FDIC-covered expenses during the first half of 2012 compared to the first half of 2011.  Deposit insurance was lower due to adjustments relating to excess deposit insurance expense that had been taken relating to the two FDIC-assisted acquisitions. Amortization of intangible assets was slightly lower due to the reduced amortization expense related to the core deposit intangible that was created as a result of previous acquisitions.  This intangible asset is being amortized over an eight-year period using the accelerated method, resulting in a progressively decreasing expense over the amortization period.  Office supplies and telephone and communications expenses were relatively unchanged during the respective six month periods.  Other real estate owned valuation adjustments and other real estate owned expenses increased due to a higher number of foreclosed properties and a decline in local real estate values for commercial land and residential development properties during the past year.  Acquisition and integration expenses decreased since there was no acquisition or integration-related expenses during the first half of 2012. Other expenses increased primarily as a result of higher deposit servicing expenses, stock-related expenses, postage and other various miscellaneous items.

Income taxes. The Company recognized an income tax benefit of $2.2 million for the six months ended June 30, 2012, compared to an income tax expense of $442,000 for the six months ended June 30, 2011.  The increase in the income tax benefit was due to the decrease in the pre-tax income in the first half of 2012 compared to the pre-tax income in the first half of 2011.

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.  As of June 30, 2012, the Company’s cash and cash equivalents totaled $128.8 million.  Of this amount, $116.6 million was held in the Company’s account with the Federal Reserve Bank.  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 $125.3 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 investment securities that are obligations of, or guaranteed by, U.S. Government Agencies, or Government Sponsored 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 available through September 30, 2012, 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 also has an unsecured federal funds accommodation with CenterState Bank of Florida in the amount of $5.0 million.  The credit facility, which is used to fund short-term liquidity needs, may be terminated at any time and may not be outstanding for more than 14 consecutive days.   The Company may also solicit brokered deposits for providing funds for asset growth.  As of June 30, 2012, the Company had no outstanding brokered deposits and $245,000 of internet deposits that were assumed from the acquisition of New Horizons Bank.  These internet deposits are not renewed at maturity. 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.

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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, 2012, the Company had loan commitments of $10.2 million, unused lines of credit of $109.5 million, and undisbursed construction loan proceeds of $795,000.  The Company also has various leases in place to provide office space for four full-service offices and one in-store office.  The current annualized cost of these leases was $678,000.  Two leases totaling approximately $176,000 expire in 2012 and are not expected to be renewed.  Short-term borrowings totaled $19.6 million at June 30, 2012.  These short-term borrowings consisted of $7.6 million of daily securities sold under repurchase agreements and $12.0 million of FHLB advances that mature over the next 12 months. The Company does not have any special purpose entities or other similar forms of off-balance-sheet financing. The Company believes that given its current level of internal and external sources of liquidity, it has adequate resources to fund loan commitments and lines of credit, repay short-term borrowings if necessary, and fund any other normal obligations that may arise in the near future.

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Capital Resources

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, 2012, are presented in the following table.

	Actual					Minimum Requirements to be Well Capitalized
	Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Regulatory Capital Ratios
Total risk-based capital (to risk-weighted assets)	$	109,394		15.59	%	$	70,739		10.00	%
Tier 1 capital (to risk-weighted assets)		100,586		14.33	%		42,444		6.00	%
Tier 1 capital (to adjusted total assets)		100,586		9.62	%		53,514		5.00	%
Tangible capital (to adjusted total assets)		100,586		9.62	%		32,108		3.00	%

On June 6, 2012, the OCC and the other federal bank regulatory agencies issued a series of proposed rules to revise their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with the agreements that were reached by the Basel Committee on Banking Supervision in "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems" ("Basel III"). The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies ("banking organizations"). Among other things, the proposed rules establish a new common equity tier 1 minimum capital requirement and a higher minimum tier 1 capital requirement, and assign higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. The proposed rules also limit a banking organization's capital distributions and certain discretionary bonus payments if the banking organization does not hold a "capital conservation buffer" consisting of a specified amount of common equity tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The final rules will become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes to the Company’s asset/liability management strategies or interest rate position that were described in Item 7A. of our Annual Report on Form 10-K for the year ended December 31, 2011.

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Item 4.  Controls and Procedures

Our management, with the participation of our Principal Executive Officer and our Principal 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.  Based upon their evaluation, our Principal Executive Officer and our Principal Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective.

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

Not applicable, as the Company is a smaller reporting company.

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

During the three months ended June 30, 2012, the Company did not have any unregistered sales of equity securities or repurchase of its common stock.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

Not applicable.

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.

101   Financial statements and related notes formatted in XBRL.

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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 14, 2012	By:	/s/ Kim S. Price
		Kim S. Price President and Chief Executive Officer
Date: August 14, 2012	By:	/s/ Gary F. Hoskins
		Gary F. Hoskins Executive Vice President, Chief Financial Officer and Treasurer

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