UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C.  20549







FORM
10-Q








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





For
the quarterly period ended June 30, 2009





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.
      Employerincorporation
      or organization)
              Identification
      Number)





519
South New Hope Road, Gastonia, NC  28054


(Address
of principal executive offices)





(704)
868-5200


(Registrant's
telephone number, including area code)








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





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





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





Large
      accelerated filer ̈
                  Accelerated
      filer ̈Non-accelerated
      filer ̈
                  Smaller
      Reporting Company x





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





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










Citizens
South Banking Corporation


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





Table
of Contents





Index





PagePART
      I.  FINANCIAL INFORMATIONItem
      1. Financial Statements:Condensed
      Consolidated Statements of Financial Condition as of June 30, 2009
      (unaudited) and December 31, 2008
                1Condensed
      Consolidated Statements of Operations for the Three and Six
      Months  Ended June 30, 2009 and 2008 (unaudited)
                2Condensed
      Consolidated Statements of Changes in Stockholders’ Equity  for
      the Six Months Ended June 30, 2009 and 2008 (unaudited)
                3Condensed
      Consolidated Statements of Cash Flows for the Six Months Ended June 30,
      2009 and 2008 (unaudited)
                4Notes
      to Condensed Consolidated Financial Statements
                5Item
      2.  Management's Discussion and Analysis of Financial Condition
      and Results of Operations
                13Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
                26Item
      4.  Controls and Procedures
                26PART II.  OTHER
      INFORMATIONItem
      1.  Legal Proceedings
                26Item
      1A.  Risk Factors
                26Item
      2.  Unregistered Sales of Equity Securities and Use of
      Proceeds
                27Item
      3.  Defaults Upon Senior Securities
                27Item
      4.  Submission of Matters to a Vote of Security
      Holders
                28Item
      5. Other Information
                28Item
      6.  Exhibits
                28Signatures
                29Certifications





PART
I.    FINANCIAL INFORMATION





ITEM
1.  Financial Statements





Citizens
South Banking Corporation


Condensed
Consolidated Statements of Financial Condition


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





June 30,
                
                
                December 31,2009
                
                
                2008(unaudited)Assets:Cash
      and cash equivalents:Cash
      and due from banks
                
                $
                8,353
                
                
                $
                9,444Interest-earning
      bank balances
                
                
                31,120
                
                
                
                613Total
      cash and cash equivalents
                
                
                39,473
                
                
                
                10,057Investment
      securities available-for-sale, at fair value
                
                
                92,378
                
                
                
                109,180Investment
      securities, held-to-maturity, at amortized cost
                
                
                5,074
                
                
                
                -Loans:Loans
      receivable, net of unearned income and deferred fees
                
                
                629,962
                
                
                
                626,688Allowance
      for loan losses
                
                
                (8,685
                )
                
                
                (8,026
                )Loans
      receivable, net
                
                
                621,277
                
                
                
                618,662Other
      real estate owned
                
                
                2,111
                
                
                
                2,601Premises
      and equipment, net
                
                
                16,383
                
                
                
                16,834Accrued
      interest receivable
                
                
                2,515
                
                
                
                2,609Federal
      Home Loan Bank common stock, at cost
                
                
                4,149
                
                
                
                4,793Bank-owned
      life insurance
                
                
                17,158
                
                
                
                16,813Intangible
      assets
                
                
                30,363
                
                
                
                30,525Other
      assets
                
                
                5,402
                
                
                
                5,139Total
      assets
                
                $
                836,283
                
                
                $
                817,213Liabilities
      and Stockholders’ Equity:Deposits:Demand
      deposit accounts
                
                $
                149,466
                
                
                $
                122,731Money
      market deposit accounts
                
                
                110,770
                
                
                
                103,271Savings
      accounts
                
                
                11,156
                
                
                
                10,708Time
      deposits
                
                
                344,841
                
                
                
                344,778Total
      deposits
                
                
                616,233
                
                
                
                581,488Borrowed
      money
                
                
                110,221
                
                
                
                124,365Deferred
      compensation
                
                
                4,935
                
                
                
                5,413Other
      liabilities
                
                
                736
                
                
                
                1,227Total
      liabilities
                
                
                732,125
                
                
                
                712,493Stockholders’
      Equity:Preferred
      stock, $0.01 par value, 10,000,000 shares authorized; 20,500 shares issued
      and outstanding at June 30, 2009 and  December 31,
      2008
                
                
                20,548
                
                
                
                20,507Common
      stock, $0.01 par value, 20,000,000 shares authorized; 9,062,727 shares
      issued at June 30, 2009 and December 31, 2008,  7,526,854 shares
      outstanding at June 30, 2009 and 7,515,957 shares  outstanding
      at December 31, 2008
                
                
                91
                
                
                
                91Additional
      paid-in-capital
                
                
                67,590
                
                
                
                67,366Unallocated
      common stock held by Employee Stock Ownership Plan
                
                
                (973
                )
                
                
                (1,064
                )Retained
      earnings
                
                
                35,350
                
                
                
                36,088Accumulated
      other comprehensive income
                
                
                (175
                )
                
                
                25Treasury
      stock of 1,535,873 shares at June 30, 2009 and 1,546,770 shares at
      December 31, 2008
                
                
                (18,273
                )
                
                
                (18,293
                )Total
      stockholders’ equity
                
                
                104,158
                
                
                
                104,720Total
      liabilities and stockholders’ equity
                
                $
                836,283
                
                
                $
                817,213




See
accompanying notes to condensed consolidated financial
statements.


1


Citizens
South Banking Corporation


Condensed Consolidated Statements of Operations(unaudited)


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





Three Months
                
                
                Six MonthsEnded June 30,
                
                
                Ended June 30,2009
                
                
                2008
                
                
                2009
                
                
                2008Interest
      Income:Loans
                
                $
                8,441
                
                
                $
                9,143
                
                
                $
                16,799
                
                
                $
                18,745Investment
      securities
                
                
                381
                
                
                
                356
                
                
                
                754
                
                
                
                769Interest-bearing
      deposits
                
                
                13
                
                
                
                42
                
                
                
                18
                
                
                
                136Mortgage-backed
      and related securities
                
                
                843
                
                
                
                942
                
                
                
                1,793
                
                
                
                1,805Total
      interest income
                
                
                9,678
                
                
                
                10,483
                
                
                
                19,364
                
                
                
                21,455Interest
      Expense:Deposits
                
                
                3,196
                
                
                
                4,334
                
                
                
                6,724
                
                
                
                9,400Borrowed
      funds
                
                
                1,150
                
                
                
                1,237
                
                
                
                2,324
                
                
                
                2,356Total
      interest expense
                
                
                4,346
                
                
                
                5,571
                
                
                
                9,048
                
                
                
                11,756Net
      interest income
                
                
                5,332
                
                
                
                4,912
                
                
                
                10,316
                
                
                
                9,699Provision
      for loan losses
                
                
                1,950
                
                
                
                750
                
                
                
                2,850
                
                
                
                1,095Net
      interest income after provision for loan losses
                
                
                3,382
                
                
                
                4,162
                
                
                
                7,466
                
                
                
                8,604Noninterest
      Income:Service
      charges on deposit accounts
                
                
                822
                
                
                
                776
                
                
                
                1,569
                
                
                
                1,454Mortgage
      banking income
                
                
                462
                
                
                
                278
                
                
                
                760
                
                
                
                481Other
      loan fees
                
                
                80
                
                
                
                102
                
                
                
                138
                
                
                
                213Dividends
      on FHLB stock
                
                
                -
                
                
                
                65
                
                
                
                -
                
                
                
                128Income
      from bank-owned life insurance
                
                
                182
                
                
                
                188
                
                
                
                368
                
                
                
                376Net
      gain on sale of assets
                
                
                235
                
                
                
                19
                
                
                
                64
                
                
                
                261Other
      noninterest income
                
                
                235
                
                
                
                164
                
                
                
                366
                
                
                
                360Total
      noninterest income
                
                
                2,016
                
                
                
                1,592
                
                
                
                3,265
                
                
                
                3,273Noninterest
      Expense:Compensation
      and benefits
                
                
                2,526
                
                
                
                2,506
                
                
                
                5,018
                
                
                
                5,047Occupancy
      and equipment expense
                
                
                652
                
                
                
                676
                
                
                
                1,326
                
                
                
                1,351Professional
      fees
                
                
                237
                
                
                
                237
                
                
                
                474
                
                
                
                438Amortization
      of intangible assets
                
                
                81
                
                
                
                135
                
                
                
                162
                
                
                
                276FDIC
      deposit insurance
                
                
                491
                
                
                
                17
                
                
                
                593
                
                
                
                34Valuation
      adjustment on other real estate owned
                
                
                50
                
                
                
                -
                
                
                
                175
                
                
                
                -Restructuring
      expenses
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                220Impairment
      of securities
                
                
                91
                
                
                
                -
                
                
                
                214
                
                
                
                -Other
      noninterest expense
                
                
                1,111
                
                
                
                1,131
                
                
                
                2,214
                
                
                
                2,219Total
      noninterest expense
                
                
                5,239
                
                
                
                4,702
                
                
                
                10,176
                
                
                
                9,585Net
      income before income taxes
                
                
                159
                
                
                
                1,052
                
                
                
                555
                
                
                
                2,292Income
      tax expense (benefit)
                
                
                (155
                )
                
                
                190
                
                
                
                (216
                )
                
                
                460Net
      income
                
                
                314
                
                
                
                862
                
                
                
                771
                
                
                
                1,832Dividends
      on preferred stock
                
                
                259
                
                
                
                -
                
                
                
                513
                
                
                
                -Net
      income available for common stockholders
                
                $
                55
                
                
                $
                862
                
                
                $
                258
                
                
                $
                1,832Net
      income per common share:Basic
                
                $
                0.01
                
                
                $
                0.12
                
                
                $
                0.03
                
                
                $
                0.25Diluted
                
                $
                0.01
                
                
                $
                0.12
                
                
                $
                0.03
                
                
                $
                0.25Weighted
      average common shares outstanding:Basic
                
                
                7,403,359
                
                
                
                7,369,964
                
                
                
                7,398,079
                
                
                
                7,391,338Diluted
                
                
                7,403,359
                
                
                
                7,434,006
                
                
                
                7,398,079
                
                
                
                7,443,803





See
accompanying notes to condensed consolidated financial
statements.


2


Citizens
South Banking Corporation


Condensed
ConsolidatedStatements of
Changes in Stockholders’ Equity(unaudited)


(Dollars
in thousands, except per share data)





Six MonthsEnded June 30,2009
                
                
                2008Preferred
      stock, $0.01 par value:At
      beginning of period
                
                $
                20,507
                
                
                $
                -Accumulated
      discount on preferred stock
                
                
                41
                
                
                
                -At
      end of period
                
                
                20,548
                
                
                
                -Common
      stock, $0.01 par value:At
      beginning of period
                
                
                91
                
                
                
                91Issuance
      of common stock
                
                
                -
                
                
                
                -At
      end of period
                
                
                91
                
                
                
                91Additional
      paid-in-capital:At
      beginning of period
                
                
                67,366
                
                
                
                67,718Vesting
      of shares for Recognition and Retention Plan
                
                
                171
                
                
                
                154Stock-based
      compensation expense
                
                
                53
                
                
                
                15At
      end of period
                
                
                67,590
                
                
                
                67,887Unallocated
      common stock held by ESOP:At
      beginning of period
                
                
                (1,064
                )
                
                
                (1,247
                )Allocation
      from shares purchased with loan from ESOP
                
                
                91
                
                
                
                91At
      end of period
                
                
                (973
                )
                
                
                (1,156
                )Retained
      earnings, substantially restricted:At
      beginning of period
                
                
                36,088
                
                
                
                36,028Net
      income
                
                
                258
                
                
                
                1,832Accumulated
      discount on preferred stock
                
                
                (41
                )
                
                
                -Stock
      options exercised
                
                
                (20
                )
                
                
                (126
                )Dividends
      paid
                
                
                (935
                )
                
                
                (1,240
                )At
      end of period
                
                
                35,350
                
                
                
                36,494Accumulated
      unrealized loss on securities available for sale, net of
    tax:At
      beginning of period
                
                
                25
                
                
                
                (343
                )Other
      comprehensive income
                
                
                (200
                )
                
                
                (1,494
                )At
      end of period
                
                
                (175
                )
                
                
                (1,837
                )Treasury
      stock:At
      beginning of period
                
                
                (18,293
                )
                
                
                (18,214
                )Stock
      options exercised
                
                
                20
                
                
                
                181Repurchase
      of common stock
                
                
                -
                
                
                
                (951
                )At
      end of period
                
                
                (18,273
                )
                
                
                (18,984
                )





See
accompanying notes to condensed consolidated financial
statements.


3





Citizens
South Banking Corporation


Condensed
ConsolidatedStatements of Cash
Flows(unaudited)


(Dollars
in thousands)




Six MonthsEnded June 30,2009
                                  
                                  
                                  2008Cash
      flows from operating activities:Net
      income
                                  
                                  $
                                  258
                                  
                                  
                                  $
                                  1,832Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for loan losses
                                  
                                  
                                  2,850
                                  
                                  
                                  
                                  1,095Depreciation
                                  
                                  
                                  537
                                  
                                  
                                  
                                  554Impairment
      on equity investment
                                  
                                  
                                  214
                                  
                                  
                                  
                                  -Net
      gain on sale of investment securities
                                  
                                  
                                  (308
                                  )
                                  
                                  
                                  (283
                                  )Net
      loss on sale of other real estate owned
                                  
                                  
                                  244
                                  
                                  
                                  
                                  22Writedown
      on other real estate owned
                                  
                                  
                                  175
                                  
                                  
                                  
                                  -Deferred
      loan origination fees
                                  
                                  
                                  7
                                  
                                  
                                  
                                  44Allocation
      of shares to the ESOP
                                  
                                  
                                  91
                                  
                                  
                                  
                                  91Stock
      based compensation
                                  
                                  
                                  53
                                  
                                  
                                  
                                  15Vesting
      of shares for the Recognition and Retention Plan
                                  
                                  
                                  171
                                  
                                  
                                  
                                  154Increase
      in accrued interest receivable
                                  
                                  
                                  94
                                  
                                  
                                  
                                  516Amortization
      of intangible assets
                                  
                                  
                                  162
                                  
                                  
                                  
                                  276Increase
      in other assets
                                  
                                  
                                  (1,964
                                  )
                                  
                                  
                                  (441
                                  )Decrease
      in other liabilities
                                  
                                  
                                  (1,233
                                  )
                                  
                                  
                                  (1,085
                                  )Net
      cash provided by operating activities
                                  
                                  
                                  1,351
                                  
                                  
                                  
                                  2,790Cash
      flows from investing activities:Net
      increase in loans
                                  
                                  
                                  (5,473
                                  )
                                  
                                  
                                  (45,425
                                  )Proceeds
      from the sale of investment securities
                                  
                                  
                                  21,566
                                  
                                  
                                  
                                  25,887Proceeds
      from the sale of premises and equipment
                                  
                                  
                                  6
                                  
                                  
                                  
                                  -Proceeds
      from the sale of other real estate owned
                                  
                                  
                                  1,552
                                  
                                  
                                  
                                  183Maturities
      and prepayments of investment securities - AFS
                                  
                                  
                                  11,523
                                  
                                  
                                  
                                  9,394Maturities
      and prepayments of investment securities - HTM
                                  
                                  
                                  11
                                  
                                  
                                  
                                  -Purchases
      of investment securities - AFS
                                  
                                  
                                  (16,518
                                  )
                                  
                                  
                                  (38,629
                                  )Purchases
      of investment securities - HTM
                                  
                                  
                                  (5,085
                                  )
                                  
                                  
                                  -(Purchases)
      sale of FHLB stock
                                  
                                  
                                  644
                                  
                                  
                                  
                                  (1,102
                                  )Capital
      expenditures for premises and equipment
                                  
                                  
                                  (92
                                  )
                                  
                                  
                                  (194
                                  )Net
      cash provided by (used in) investment activities
                                  
                                  
                                  8,134
                                  
                                  
                                  
                                  (49,886
                                  )Cash
      flows from financing activities:Net
      increase (decrease) in deposits
                                  
                                  
                                  34,746
                                  
                                  
                                  
                                  (5,964
                                  )Net
      increase (decrease) in borrowed money
                                  
                                  
                                  (14,144
                                  )
                                  
                                  
                                  40,994Dividends
      paid
                                  
                                  
                                  (935
                                  )
                                  
                                  
                                  (1,240
                                  )Issuance
      of common stock for options
                                  
                                  
                                  -
                                  
                                  
                                  
                                  55Repurchase
      of common stock
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (951
                                  )Increase
      in advances from borrowers for insurance and taxes
                                  
                                  
                                  264
                                  
                                  
                                  
                                  277Net
      cash provided by financing activities
                                  
                                  
                                  19,931
                                  
                                  
                                  
                                  33,171Net
      increase (decrease) in cash and cash equivalents
                                  
                                  
                                  29,416
                                  
                                  
                                  
                                  (13,925
                                  )Cash
      and cash equivalents at beginning of period
                                  
                                  
                                  10,057
                                  
                                  
                                  
                                  29,739Cash
      and cash equivalents at end of period
                                  
                                  $
                                  39,473
                                  
                                  
                                  $
                                  15,814Supplemental
      non-cash investing activity:Reclassification
      of loans to other real estate owned
                                  
                                  $
                                  1,688
                                  
                                  
                                  $
                                  324





See
accompanying notes to condensed consolidated financial
statements.


4


CITIZENS
SOUTH BANKING CORPORATION


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Note
1 – Basis of Presentation





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





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





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





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





Note
2 - Recent Accounting Pronouncements





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





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





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


5





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





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





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





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





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





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


6





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





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





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





Note
3 – Fair Value Measurements





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





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


7





The
Company utilizes fair value measurements to record fair value adjustments to
certain assets and to determine fair value disclosures.  The Company
has not elected the fair value option for liabilities.  Investment
securities, available-for-sale, are recorded at fair value on a recurring
basis.  Additionally, the Company may be required to record at fair
value other assets on a nonrecurring basis, such as impaired loans and other
real estate owned.  These nonrecurring fair value adjustments
typically involve the application of lower of cost or market accounting for
these other assets.  The application of SFAS No. 157 in situations
where the market for a financial asset is not active was clarified by the
issuance of SFAS No. 157-4 as outlined in Note 2.





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





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





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





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





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





Investment
Securities, Available-for-Sale–Investment securities
available-for-sale are recorded at fair value on at least a monthly
basis.  Fair value measurement is based upon quoted prices, if
available.  If quoted prices are not available, fair values are
measured using independent pricing models or other model-based valuation
techniques such as the present value of future cash flows, adjusted for the
security’s credit rating, prepayment assumptions and other factors such as
credit loss assumptions.  Level 1 fair value is used for those
securities traded on an active exchange, U.S. Treasury securities that are
traded by brokers or dealers in an active over-the-counter market, and money
market funds.  Level 2 securities include mortgage-backed securities
issued by government-sponsored enterprises, municipal bonds, and corporate debt
securities.  Securities valued using Level 3 include equity securities
that are not traded on an active exchange, investments in closely held
subsidiaries, and asset-backed securities traded in less liquid
markets.




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


8




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





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





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





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





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





Note
4 – Computation of Earnings per Share





The
Company is required to report both basic and diluted earnings per share
(“EPS”).  Basic EPS is calculated by dividing net income available to
common stockholders by the weighted average number of common shares outstanding
for the period.  Diluted EPS is calculated by dividing net income
available to common stockholders by the sum of the weighted average number of
common shares outstanding for the period and potential common stock. Potential
common stock consists of additional common stock that would have been
outstanding as a result of the exercise of dilutive stock options.  In
determining the number of shares of potential common stock, the treasury stock
method was applied.  The treasury method assumes that the number of
shares issuable upon exercise of the stock options is reduced by the number of
common shares assumed purchased at market prices with the proceeds from the
assumed exercise of the common stock options plus any tax benefits received as a
result of the assumed exercise.





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


9


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




Three Months
                    Ended June 30,
                  
                  
                  Six Months
                    Ended June 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008(dollars in thousands, except per share amounts)Net
      income available to common stockholders
                  
                  $
                  55
                  
                  
                  $
                  862
                  
                  
                  $
                  258
                  
                  
                  $
                  1,832Shares
      used in the computation of EPS:Weighted
      avg. number of shares outstanding
                  
                  
                  7,403,359
                  
                  
                  
                  7,369,964
                  
                  
                  
                  7,398,079
                  
                  
                  
                  7,391,338Incremental
      shares from assumed exercise of stock options
                  
                  
                  -
                  
                  
                  
                  64,042
                  
                  
                  
                  -
                  
                  
                  
                  52,465Weighted
      average number of shares outstanding - diluted
                  
                  
                  7,403,359
                  
                  
                  
                  7,434,006
                  
                  
                  
                  7,398,079
                  
                  
                  
                  7,443,803Diluted
      EPS
                  
                  $
                  0.01
                  
                  
                  $
                  0.12
                  
                  
                  $
                  0.03
                  
                  
                  $
                  0.25





Note
5 – Comprehensive Income





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





Six MonthsEnded June 30,2009
                  
                  
                  2008(Dollars in thousands)Net
      income available to common stockholders
                  
                  $
                  258
                  
                  
                  $
                  1,832Other
      comprehensive income:Items
      of other comprehensive income, before taxUnrealized
      gains arising during period
                  
                  
                  633
                  
                  
                  
                  2,713Reclassification
      for realized losses included in net income
                  
                  
                  (308
                  )
                  
                  
                  (283
                  )Other
      comprehensive income, before tax
                  
                  
                  325
                  
                  
                  
                  2,430Tax
      benefit
                  
                  
                  (125
                  )
                  
                  
                  (936
                  )Other
      comprehensive income
                  
                  
                  200
                  
                  
                  
                  1,494Total
      comprehensive income
                  
                  $
                  458
                  
                  
                  $
                  3,326





Note
6 – Commitments to Extend Credit





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


10





Commitments
to extend credit that include both fixed and variable rates are as
follows:





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





Note
7 – Dividend Declaration





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





Note
8 – Stock Repurchase Program





In June
2008, the Board of Directors of the Company authorized the repurchase of up to
200,000 shares, or approximately 2.7% of the Company’s then outstanding shares
of common stock. These repurchases may be carried out through open market
purchases, block trades, and negotiated private transactions. The stock may be
repurchased on an ongoing basis and will be subject to the availability of
stock, general market conditions, the trading price of the stock, alternative
uses for capital, and the Company’s financial performance. As of June 30, 2009,
the Company had repurchased a total of 9,476 shares at an average price of $7.91
per share and had 190,524 shares remaining to be repurchased under the
plan.  On December 12, 2008, the Company entered into a Letter
Agreement with the United States Department of the Treasury ("U.S. Treasury")
pursuant to which the Company has issued and sold to the U.S. Treasury: (i)
20,500 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock,
Series A, par value $0.01 per share, having a liquidation amount per share equal
to $1,000, for a total price of $20,500,000 and (ii) a warrant to purchase
428,870 shares of the Company's common stock, par value $0.01 per share, at an
exercise price per share of $7.17.  As a condition for issuing the
preferred stock under the U.S. Treasury Capital Purchase Program (“CPP”), the
U.S. Treasury limited the Company’s ability to repurchase common stock of the
Company and increase its dividend payments to stockholders without receiving
prior approval from the U.S. Treasury.   As a result, future
repurchases of Company common stock are not anticipated for 2009.





Note
9 - Fair Value of Financial Instruments





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





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





11




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





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





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





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





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





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





June 30, 2009
                  
                  
                  December 31, 2008Carrying
                    Amount
                  
                  
                  Estimated
                    Fair Value
                  
                  
                  Carrying
                    Amount
                  
                  
                  Estimated
                    Fair ValueFinancial
      assets:Cash
      and due from banks
                  
                  $
                  8,353
                  
                  
                  $
                  8,353
                  
                  
                  $
                  9,444
                  
                  
                  $
                  9,444Interest-earning
      bank balances
                  
                  
                  31,120
                  
                  
                  
                  31,120
                  
                  
                  
                  613
                  
                  
                  
                  613Investment
      securities
                  
                  
                  97,452
                  
                  
                  
                  97,738
                  
                  
                  
                  109,180
                  
                  
                  
                  108,751Loans
                  
                  
                  629,962
                  
                  
                  
                  640,389
                  
                  
                  
                  626,688
                  
                  
                  
                  639,505Financial
      liabilities:Deposits
                  
                  
                  616,233
                  
                  
                  
                  605,840
                  
                  
                  
                  581,488
                  
                  
                  
                  577,876Borrowed
      money
                  
                  
                  110,221
                  
                  
                  
                  125,876
                  
                  
                  
                  124,365
                  
                  
                  
                  128,137





Note
10 – Subsequent Events





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


12
  ITEM
2.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations
  Forward
Looking Statements
 
 This
report contains certain forward-looking statements that represent the Company's
expectations or beliefs concerning future events. Such forward-looking
statements are based on our current beliefs and expectations and are inherently
subject to significant business, economic, and competitive uncertainties and
contingencies, many of which are beyond our control.  These
forward-looking statements are based on assumptions with respect to future
business strategies and decisions that are subject to change based on changes in
the economic and competitive environment in which we
operate.  Forward-looking statements speak only as of the date they
are made and the Company is under no duty to update these forward-looking
statements or to reflect the occurrence of unanticipated events.  A
number of factors could cause actual conditions, events, or results to differ
significantly from those described in the forward-looking
statements.   Factors that could cause such a difference include,
but are not limited to, the timing and amount of revenues that may be recognized
by the Company, changes in local or national economic trends, increased
competition among depository and financial institutions, continuation of current
revenue and expense trends (including trends affecting chargeoffs and provisions
for loan losses), changes in interest rates, changes in the shape of the yield
curve, changes in the level of non-performing assets and charge-offs, changes in
estimates of future reserve requirements based upon the periodic review
thereof under relevant regulatory and accounting requirements, the level of
future deposit premium assessments, our ability to raise capital to fund our
growth plans or operations, the impact of the current governmental effort to
restructure the U.S. financial and regulatory system, the quality and
composition of the Company’s investment portfolio and adverse legal, regulatory
or accounting changes. Because of the risks and uncertainties inherent in
forward-looking statements, readers are cautioned not to place undue reliance on
these statements.    Readers should carefully review the
risk factors described in other documents the Company files from time to time
with the SEC, including annual reports on Form 10-K, quarterly reports on Form
10-Q, and Current Reports on Form 8-K.
 
 Executive
Summary
 
 Citizens
South Banking Corporation is a Delaware corporation that owns all of the
outstanding shares of common stock of Citizens South Bank (the
"Bank").  The Company’s principal business activities are overseeing
and directing the business of the Bank. The Company’s assets consist primarily
of the outstanding capital stock of the Bank, deposits held at the Bank, and
investment securities. The shares of common stock of the Company trade on the
Nasdaq Global Market under the ticker symbol “CSBC.”  Citizens South
Bank, which was chartered in 1904, is a federally chartered savings bank
headquartered in Gastonia, North Carolina.  The Bank’s principal
business activity is offering FDIC-insured deposits to local customers through
its 15 branch offices and investing those deposits, together with funds
generated from operations and borrowings, in residential and nonresidential real
estate loans, construction loans, commercial business loans, consumer loans,
investment securities, and mortgage-backed securities.  The Bank also
acts as a broker in both the origination of loans secured by one-to-four family
dwellings and in the sale of uninsured financial products. The Bank’s results of
operations are heavily dependent on net interest income, which is the difference
between the interest earned on loans and securities and the interest paid on
deposits and borrowings.  Results of operations are also materially
affected by the Bank’s provision for loan losses, noninterest income, and
noninterest expense.  Noninterest income includes fee income generated
from deposit and loan accounts, mortgage banking fees, increases in the cash
value of bank-owned life insurance policies, net gains (losses) from the sale of
assets and other noninterest income items.  The Bank’s noninterest
expense primarily consists of compensation and employee benefits, occupancy
expense, professional services, amortization of intangible assets, FDIC deposit
insurance premiums and other noninterest expenses.  Results of
operations are also significantly affected by local economic and competitive
conditions, changes in interest rates, and actions of regulatory and
governmental authorities.
 
 The
following discussion is provided to assist in understanding and evaluating the
Company’s results of operations and financial condition and is designed to
provide a general overview of the Company’s performance for the three- and
six-month periods ended June 30, 2009 and 2008.  Readers seeking a
more in-depth analysis should read the detailed discussions below, as well as
the condensed consolidated financial statements and related
notes.  Financial highlights for the comparable periods are presented
in the following table.




13





Financial Highlights:(unaudited)
                        (Dollars in thousands, except per share data)
                      
                      Three months
                        ended
                        June 30, 2009
                      
                      
                      Three months
                        ended
                        June 30, 2008
                      
                      
                      % Change
                      
                      
                      Six months
                        ended
                        June 30, 2009
                      
                      
                      Six months
                        ended
                        June 30, 2008
                      
                      
                      % ChangeSummary
      Income Statement:Interest
      income – taxable equivalent
                      
                      $
                      9,819
                      
                      
                      $
                      10,619
                      
                      
                      
                      (7.5
                      )%
                      
                      $
                      19,650
                      
                      
                      $
                      21,715
                      
                      
                      
                      (9.5
                      )%Interest
      expense
                      
                      
                      4,346
                      
                      
                      
                      5,571
                      
                      
                      
                      (22.0
                      )
                      
                      
                      9,048
                      
                      
                      
                      11,756
                      
                      
                      
                      (23.0
                      )Net
      interest income – taxable equivalent
                      
                      
                      5,473
                      
                      
                      
                      5,048
                      
                      
                      
                      8.4
                      
                      
                      
                      10,602
                      
                      
                      
                      9,959
                      
                      
                      
                      6.5Less:
      Taxable-equivalent adjustment
                      
                      
                      141
                      
                      
                      
                      136
                      
                      
                      
                      3.6
                      
                      
                      
                      286
                      
                      
                      
                      260
                      
                      
                      
                      10.0Net
      interest income
                      
                      
                      5,332
                      
                      
                      
                      4,912
                      
                      
                      
                      8.6
                      
                      
                      
                      10,316
                      
                      
                      
                      9,699
                      
                      
                      
                      6.4Provision
      for loan losses
                      
                      
                      (1,950
                      )
                      
                      
                      (750
                      )
                      
                      
                      160.0
                      
                      
                      
                      (2,850
                      )
                      
                      
                      (1,095
                      )
                      
                      
                      160.3Noninterest
      income
                      
                      
                      2,016
                      
                      
                      
                      1,592
                      
                      
                      
                      26.6
                      
                      
                      
                      3,265
                      
                      
                      
                      3,273
                      
                      
                      
                      (0.3
                      )Noninterest
      expense
                      
                      
                      (5,239
                      )
                      
                      
                      (4,702
                      )
                      
                      
                      11.4
                      
                      
                      
                      (10,176
                      )
                      
                      
                      (9,585
                      )
                      
                      
                      6.2Income
      tax (expense) benefit
                      
                      
                      155
                      
                      
                      
                      (190
                      )
                      
                      
                      (181.6
                      )
                      
                      
                      216
                      
                      
                      
                      (460
                      )
                      
                      
                      (147.0
                      )Net
      income
                      
                      
                      314
                      
                      
                      
                      862
                      
                      
                      
                      (63.6
                      )
                      
                      
                      771
                      
                      
                      
                      1,832
                      
                      
                      
                      (57.9
                      )Dividends
      on preferred stock
                      
                      
                      (259
                      )
                      
                      
                      -
                      
                      
                      NM
                      
                      
                      
                      (513
                      )
                      
                      
                      -
                      
                      
                      NMNet
      Income available to common  stockholders
                      
                      $
                      55
                      
                      
                      $
                      862
                      
                      
                      
                      (93.6
                      )%
                      
                      $
                      258
                      
                      
                      $
                      1,832
                      
                      
                      
                      (85.9
                      )%Per
      Common Share Data:Earnings:Basic
                      
                      $
                      0.01
                      
                      
                      $
                      0.12
                      
                      
                      
                      (91.7
                      )%
                      
                      $
                      0.03
                      
                      
                      $
                      0.25
                      
                      
                      
                      (88.0
                      )%Diluted
                      
                      
                      0.01
                      
                      
                      
                      0.12
                      
                      
                      
                      (91.7
                      )
                      
                      
                      0.03
                      
                      
                      
                      0.25
                      
                      
                      
                      (88.0
                      )Weighted
      average shares:Basic
                      
                      
                      7,403,359
                      
                      
                      
                      7,369,964
                      
                      
                      
                      0.5
                      %
                      
                      
                      7,398,079
                      
                      
                      
                      7,391,338
                      
                      
                      
                      0.1
                      %Diluted
                      
                      
                      7,403,359
                      
                      
                      
                      7,434,006
                      
                      
                      
                      (0.3
                      )
                      
                      
                      7,398,079
                      
                      
                      
                      7,443,803
                      
                      
                      
                      (0.6
                      )End
      of period shares outstanding
                      
                      
                      7,526,854
                      
                      
                      
                      7,524,016
                      
                      
                      
                      0.4
                      
                      
                      
                      7,526,854
                      
                      
                      
                      7,524,016
                      
                      
                      
                      0.4Cash
      dividends paid
                      
                      $
                      0.04
                      
                      
                      $
                      0.085
                      
                      
                      
                      (52.9
                      )%
                      
                      $
                      0.125
                      
                      
                      
                      0.17
                      
                      
                      
                      (26.5
                      )%Book
      value
                      
                      
                      11.11
                      
                      
                      
                      10.26
                      
                      
                      
                      8.3
                      
                      
                      
                      11.11
                      
                      
                      
                      10.96
                      
                      
                      
                      1.4Tangible
      book value
                      
                      
                      7.07
                      
                      
                      
                      6.88
                      
                      
                      
                      2.8
                      
                      
                      
                      7.07
                      
                      
                      
                      6.88
                      
                      
                      
                      2.8End
      of Period Balances:Total
      assets
                      
                      $
                      836,283
                      
                      
                      $
                      811,825
                      
                      
                      
                      3.0
                      %
                      
                      $
                      836,283
                      
                      
                      $
                      811,825
                      
                      
                      
                      3.0
                      %Loans,
      net of deferred fees
                      
                      
                      629,962
                      
                      
                      
                      604,855
                      
                      
                      
                      4.2
                      
                      
                      
                      629,962
                      
                      
                      
                      604,855
                      
                      
                      
                      4.2Investment
      securities
                      
                      
                      97,452
                      
                      
                      
                      117,613
                      
                      
                      
                      (17.1
                      )
                      
                      
                      97,452
                      
                      
                      
                      117,613
                      
                      
                      
                      (17.1
                      )Interest-earning
      assets
                      
                      
                      751,733
                      
                      
                      
                      720,270
                      
                      
                      
                      4.4
                      
                      
                      
                      751,733
                      
                      
                      
                      670,270
                      
                      
                      
                      12.2Deposits
                      
                      
                      616,233
                      
                      
                      
                      584,801
                      
                      
                      
                      5.4
                      
                      
                      
                      616,233
                      
                      
                      
                      584,801
                      
                      
                      
                      5.4Stockholders’
      equity
                      
                      
                      104,158
                      
                      
                      
                      82,495
                      
                      
                      
                      26.3
                      
                      
                      
                      104,158
                      
                      
                      
                      82,495
                      
                      
                      
                      26.7Average
      Balances:Total
      assets
                      
                      $
                      841,169
                      
                      
                      $
                      790,625
                      
                      
                      
                      6.4
                      %
                      
                      $
                      832,937
                      
                      
                      $
                      783,148
                      
                      
                      
                      6.4
                      %Loans,
      net of deferred fees
                      
                      
                      635,645
                      
                      
                      
                      588,868
                      
                      
                      
                      7.9
                      
                      
                      
                      631,184
                      
                      
                      
                      577,953
                      
                      
                      
                      9.2Investment
      securities
                      
                      
                      107,140
                      
                      
                      
                      110,903
                      
                      
                      
                      (3.4
                      )
                      
                      
                      108,836
                      
                      
                      
                      111,766
                      
                      
                      
                      (2.6
                      )Interest-earning
      assets
                      
                      
                      751,381
                      
                      
                      
                      695,151
                      
                      
                      
                      8.1
                      
                      
                      
                      745,893
                      
                      
                      
                      687,863
                      
                      
                      
                      8.4Deposits
                      
                      
                      616,936
                      
                      
                      
                      578,469
                      
                      
                      
                      6.7
                      
                      
                      
                      605,046
                      
                      
                      
                      624,136
                      
                      
                      
                      4.5Interest-bearing
      liabilities
                      
                      
                      685,109
                      
                      
                      
                      655,533
                      
                      
                      
                      4.5
                      
                      
                      
                      678,699
                      
                      
                      
                      646,204
                      
                      
                      
                      5.0Stockholders’
      equity
                      
                      
                      104,813
                      
                      
                      
                      83,965
                      
                      
                      
                      24.8
                      
                      
                      
                      104,875
                      
                      
                      
                      84,205
                      
                      
                      
                      24.6Financial
      Performance Ratios:Return
      on average assets
                      
                      
                      0.03
                      %
                      
                      
                      0.44
                      %
                      
                      
                      (93.2
                      )%
                      
                      
                      0.06
                      %
                      
                      
                      0.47
                      %
                      
                      
                      (87.2
                      )%Return
      on average common equity
                      
                      
                      0.26
                      
                      
                      
                      4.13
                      
                      
                      
                      (93.7
                      )
                      
                      
                      0.62
                      
                      
                      
                      4.38
                      
                      
                      
                      (85.8
                      )Noninterest
      income to average assets
                      
                      
                      0.96
                      
                      
                      
                      0.81
                      
                      
                      
                      18.3
                      
                      
                      
                      0.78
                      
                      
                      
                      0.84
                      
                      
                      
                      (6.2
                      )Noninterest
      expense to average assets
                      
                      
                      2.49
                      
                      
                      
                      2.38
                      
                      
                      
                      4.7
                      
                      
                      
                      2.44
                      
                      
                      
                      2.45
                      
                      
                      
                      (0.2
                      )Efficiency
      ratio
                      
                      
                      71.29
                      
                      
                      
                      72.29
                      
                      
                      
                      (1.4
                      )
                      
                      
                      75.58
                      
                      
                      
                      73.89
                      
                      
                      
                      2.3





NM = Not
Meaningful


14





Financial Highlights:(unaudited)
                        (Dollars in thousands, except per share data)
                      
                      Three months
                        ended
                        June 30, 2009
                      
                      
                      Three months
                        ended
                        June 30, 2008
                      
                      
                      % Change
                      
                      
                      Six months
                        ended
                        June 30, 2009
                      
                      
                      Six months
                        ended
                        June 30, 2008
                      
                      
                      % ChangeNet
      Interest Spread / Margin:Yield
      on earnings assets
                      
                      
                      5.26
                      %
                      
                      
                      6.12
                      %
                      
                      
                      (14.1
                      )%
                      
                      
                      5.32
                      %
                      
                      
                      6.33
                      %
                      
                      
                      (16.0
                      )%Cost
      of funds
                      
                      
                      2.54
                      
                      
                      
                      3.41
                      
                      
                      
                      (25.5
                      )
                      
                      
                      2.72
                      
                      
                      
                      3.65
                      
                      
                      
                      (25.5
                      )Net
      interest spread
                      
                      
                      2.72
                      
                      
                      
                      2.71
                      
                      
                      
                      0.4
                      
                      
                      
                      2.60
                      
                      
                      
                      2.68
                      
                      
                      
                      (3.0
                      )Net
      interest margin
                      
                      
                      2.92
                      
                      
                      
                      2.91
                      
                      
                      
                      0.3
                      
                      
                      
                      2.87
                      
                      
                      
                      2.90
                      
                      
                      
                      (1.0
                      )Credit
      Quality Data:Allowance
      for loan losses (ALLL):Beginning
      of period
                      
                      $
                      8,730
                      
                      
                      $
                      6,428
                      
                      
                      
                      36.8
                      %
                      
                      $
                      8,026
                      
                      
                      $
                      6,144
                      
                      
                      
                      30.6
                      %Add:  Provision
      for loan losses
                      
                      
                      1,950
                      
                      
                      
                      750
                      
                      
                      
                      160.0
                      
                      
                      
                      2,850
                      
                      
                      
                      1,095
                      
                      
                      
                      160.3Less:  Net
      charge-offs
                      
                      
                      1,995
                      
                      
                      
                      421
                      
                      
                      
                      373.8
                      
                      
                      
                      2,191
                      
                      
                      
                      482
                      
                      
                      
                      354.6Balance
      end of period
                      
                      
                      8,685
                      
                      
                      
                      6,757
                      
                      
                      
                      28.5
                      
                      
                      
                      8,685
                      
                      
                      
                      6,757
                      
                      
                      
                      28.5Nonperforming
      loans (NPLs)
                      
                      $
                      10,360
                      
                      
                      $
                      3,880
                      
                      
                      
                      167.0
                      %
                      
                      $
                      10,360
                      
                      
                      $
                      3,880
                      
                      
                      
                      167.0
                      %Other
      real estate owned
                      
                      
                      2,111
                      
                      
                      
                      635
                      
                      
                      
                      232.4
                      
                      
                      
                      2,111
                      
                      
                      
                      635
                      
                      
                      
                      232.4Nonperforming
      assets (NPAs)
                      
                      
                      12,471
                      
                      
                      
                      4,515
                      
                      
                      
                      176.2
                      
                      
                      
                      12,471
                      
                      
                      
                      4,515
                      
                      
                      
                      176.2Allowance
      for loan losses to total loans
                      
                      
                      1.38
                      %
                      
                      
                      1.12
                      %
                      
                      
                      23.4
                      %
                      
                      
                      1.38
                      %
                      
                      
                      1.12
                      %
                      
                      
                      23.4
                      %Net
      charge-offs to average loans
                      
                      
                      0.31
                      
                      
                      
                      0.07
                      
                      
                      
                      339.0
                      
                      
                      
                      0.35
                      
                      
                      
                      0.08
                      
                      
                      
                      336.5NPLs
      to total loans
                      
                      
                      1.64
                      
                      
                      
                      0.64
                      
                      
                      
                      156.4
                      
                      
                      
                      1.64
                      
                      
                      
                      0.64
                      
                      
                      
                      156.4NPAs
      to total assets
                      
                      
                      1.49
                      
                      
                      
                      0.56
                      
                      
                      
                      164.1
                      
                      
                      
                      1.49
                      
                      
                      
                      0.56
                      
                      
                      
                      164.1NPAs
      to total loans and OREO
                      
                      
                      1.97
                      
                      
                      
                      0.75
                      
                      
                      
                      164.6
                      
                      
                      
                      1.97
                      
                      
                      
                      0.75
                      
                      
                      
                      164.6Capital
      Ratios:Tangible
      common equity
                      
                      
                      6.61
                      %
                      
                      
                      6.88
                      %
                      
                      
                      (3.9
                      )%
                      
                      
                      6.61
                      %
                      
                      
                      6.88
                      %
                      
                      
                      (3.9
                      )%Bank-only
      regulatory capital ratios:Tier
      1
                      
                      
                      10.35
                      
                      
                      
                      8.46
                      
                      
                      
                      1.9
                      
                      
                      
                      10.35
                      
                      
                      
                      8.46
                      
                      
                      
                      1.9Total
      risk-based
                      
                      
                      14.31
                      
                      
                      
                      10.84
                      
                      
                      
                      3.5
                      
                      
                      
                      14.31
                      
                      
                      
                      10.84
                      
                      
                      
                      3.5Tier
      1 risk-based
                      
                      
                      13.27
                      
                      
                      
                      9.84
                      
                      
                      
                      3.4
                      
                      
                      
                      13.27
                      
                      
                      
                      9.84
                      
                      
                      
                      3.4Tangible
      equity
                      
                      
                      10.35
                      
                      
                      
                      8.46
                      
                      
                      
                      1.9
                      
                      
                      
                      10.35
                      
                      
                      
                      8.46
                      
                      
                      
                      1.9


15


Critical
Accounting Policies





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





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





Other-Than-Temporary Impairment of
Securities.On at least a quarterly basis management reviews
all investment securities with significant declines in fair value for potential
other-than-temporary impairment pursuant to the guidance provided by SFAS No.
115, “Accounting for Certain
Investments in Debt and Equity Securities.”In November 2007,
the FASB issued Staff Position (“FSP”) FAS No. 115-1 and FAS No. 124-1, “The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments.”  The
FSP addressed the determination as to when an investment is considered impaired,
whether the impairment is other-than-temporary, and the measurement of an
impairment loss.  It also included accounting considerations
subsequent to the recognition of an other-than-temporary impairment and requires
certain disclosures about unrealized losses that have not been recognized as
other-than-temporary impairments.  The guidance in this FSP amended
SFAS No. 115, “Accounting for
Certain Investments in Debt and Equity Securities,”FASNo. 124,”Accounting for Certain Investments
Held by Not-for-Profit Organizations,”and APB Opinion 18, “The Equity Method of Accounting for
Investments in Common Stock.”





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


16





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





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


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


Level
3:   Unobservable inputs.





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





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





Comparison
of Financial Condition





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





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





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





While the
economy in the Charlotte region has generally outperformed most other large
metropolitan areas of the country, the economy in the Charlotte region continued
to slow during 2009.  As a result, the Company’s loan production
slowed to $75.7 million during the first six months of 2009 as compared to
$158.7 million during the first six months of 2008.    A
continued slowdown in the local economy would have a negative impact on the
Company’s ability to increase the current level of loan growth. Management will
seek to continue to grow the loan portfolio in a prudent manner with an emphasis
on borrowers that have a demonstrated capacity to meet their debt obligations,
even if the local economy continues to slow.





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


17


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


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





Allowance for
loan losses and nonperforming assets.The Company has
established a systematic methodology for determining the adequacy of the
allowance for loan losses.  This methodology is set forth in a formal
policy and considers all loans in the portfolio.  Specific allowances
are established for certain individual loans that management considers
impaired.  The remainder of the portfolio is segmented into groups of
loans with similar risk characteristics for evaluation and analysis.
Management’s periodic evaluation of the allowance is consistently applied and
based on inherent losses in the portfolio, past loan loss experience, risks
inherent in the different types of loans, the estimated value of any underlying
collateral, current economic conditions, the borrower’s financial position, and
other relevant internal and external factors that may affect loan
collectibility. The allowance for loan losses is increased by charging
provisions for loan losses against income.  As of June 30, 2009, the
allowance for loan losses was $8.7 million, or 1.38% of total
loans.  Management believes that this amount meets the requirement for
losses on loans that management considers to be impaired, for known losses, and
for losses inherent in the remaining loan portfolio.  Although
management believes that it uses the best information available to make such
determinations, future adjustments to the allowance for loan losses may be
necessary and results of operations could be significantly adversely affected if
circumstances differ substantially from the assumptions used in making the
determinations.  The following table presents an analysis of changes
in the allowance for loan losses for the comparable periods and information with
respect to nonperforming assets at the dates indicated.


18





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





At June 30, 2009
                  
                  
                  At June 30, 2008Nonperforming
      assets:Nonperforming loans(1)
                  
                  $
                  10,360
                  
                  
                  $
                  3,880Other
      real estate owned
                  
                  
                  2,111
                  
                  
                  
                  635Nonperforming
      assets
                  
                  $
                  12,471
                  
                  
                  $
                  4,515Credit
      Quality Ratios:Nonperforming
      loans to total loans
                  
                  
                  1.64
                  %
                  
                  
                  0.64
                  %Nonperforming
      assets to total assets
                  
                  
                  1.49
                  %
                  
                  
                  0.56
                  %Nonperforming
      assets to total loans and OREO
                  
                  
                  1.97
                  %
                  
                  
                  0.75
                  %Allowance
      for loan losses as a percentage of total loans
                  
                  
                  1.38
                  %
                  
                  
                  1.12
                  %





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





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





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





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


19





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





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





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





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





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





The
Company’s net interest margin increased by one basis point to 2.92% for the
quarter ended June 30, 2009, compared to 2.91% for the quarter ended June 30,
2008.  This slight increase in the net interest margin was the result
of the cost of funds falling at a faster rate than the yield on assets. On a
linked-quarter basis, the Company’s net interest margin increased 11 basis
points from 2.81% for the first quarter of 2009 to 2.92% for the second quarter
of 2009.  While the Company maintains a relatively neutral interest
rate risk position on a cumulative one-year basis, the Federal Reserve Board’s
action to lower short-term interest rates by 200 basis points in the fourth
quarter of 2008 will have a more pronounced negative impact in the first three
months following the decrease in short-term interest rates.  The
short-term negative effects of a decrease in interest rates are expected to be
mostly offset by time deposits that mature over the next 12 months and reprice
at a lower cost to the Company.





Provision for
loan losses.Due to the general weakness in the local economy and an
increase in nonperforming assets, the Company increased its provision for loan
losses to $2.0 million for the second quarter of 2009 compared to $750,000 for
the second quarter of 2008.  As a result, the allowance for loan
losses was $8.7 million, or 1.38% of total loans, as of June 30, 2009, compared
to $6.8 million, or 1.12% of total loans, as of June 30, 2008.  While
the Company’s credit quality continues to compare favorable with industry peers,
the continued decline in local economic conditions has resulted in an upward
trend in the Company’s loan delinquency ratios.   The Company’s
ratio of non-performing assets to total assets increased from 0.56% at June 30,
2008, to 1.49% at June 30, 2009. A substantial portion of the Company’s
nonperforming loans at June 30, 2009, was secured by real estate located in the
Company’s normal lending market.  Net chargeoffs totaled $2.0 million,
or 0.32% of average loans, during the second quarter of 2009 compared to
$421,000, or 0.07% of average loans, during the second quarter of 2008.
Management expects that the Company will continue to experience larger loan loss
provisions over the foreseeable future.


20




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





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





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





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





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





Income
taxes.Income taxes amounted
to a benefit of $155,000 for the quarter ended June 30, 2009.  This
benefit was largely due to the fact that nontaxable income generated from
interest earned on bank-qualified municipal securities and loans exceeded the
Company’s provision for taxable income.  This nontaxable income was
primarily generated from interest earned on bank-qualified municipal securities
and increases in cash value on bank-owned life insurance
policies.  The Company invests in tax-advantaged sources of income to
reduce its overall tax burden.  However, as the Company continues to
increase the amount of income derived from interest income on loans and fee
income on loans and deposits, the effective tax rate is expected to increase.
During the second quarter of 2008 the Company’s income tax expense totaled
$190,000, or 18.1% of taxable income.


21





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





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





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





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





As a
result of the decrease in interest rates during the comparable periods, the
Company’s net interest margin decreased by three basis points to 2.87% for the
six months ended June 30, 2009, compared to 2.90% for the six months ended June
30, 2008. This decrease in the net interest margin was primarily the result of
yields on earning assets falling at a faster rate than the cost of funds.
However, on a linked-quarter basis, the Company’s net interest margin increased
by 11 basis points from 2.81% for the first quarter of 2009 to 2.92% for the
second quarter of 2009.  While the Company maintains a relatively
neutral interest rate risk position on a cumulative one-year basis, the Federal
Reserve Board’s action to lower short-term interest rates by 200 basis points in
the fourth quarter of 2008 have had a more pronounced negative impact during the
first six months following the decrease in short-term interest
rates.  The short-term negative effects of the decrease in interest
rates are expected to be mostly offset by time deposits that mature over the
next 12 months and reprice at a lower cost to the Company.





Provision for
loan losses.Due to the general weakness in the local economy and an
increase in nonperforming assets, the Company increased its provision for loan
losses to $2.9 million for the first six months of 2009 compared to $1.1 million
for the first six months of 2008.  As a result, the allowance for loan
losses was $8.7 million, or 1.38% of total loans, as of June 30, 2009, compared
to $6.8 million, or 1.12% of total loans, as of June 30, 2008.  While
the Company’s credit quality continues to compare favorably with industry peers,
the continued decline in local economic conditions has resulted in an upward
trend in the Company’s loan delinquency ratios.   The Company’s
ratio of non-performing assets to total assets increased from 0.56% at June 30,
2008, to 1.49% at June 30, 2009. A substantial portion of the Company’s
nonperforming loans at June 30, 2009, was secured by real estate located in the
Company’s normal lending market.  Net charge offs totaled $2.2
million, or 0.35% of average loans, during the first half of 2009 compared to
$482,000, or 0.08% of average loans, during the first half of 2008. Management
expects that the Company will continue to experience larger loan loss provisions
over the foreseeable future.


22


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





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





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





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





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





Income
taxes.Income taxes amounted
to a benefit of $216,000 for the six months ended June 30, 2009.  This
benefit was largely due to the fact that nontaxable income generated from
interest earned on bank-qualified municipal securities and loans exceeded the
Company’s provision for taxable income.  This nontaxable income was
primarily generated from interest earned on bank-qualified municipal securities
and increases in cash value on bank-owned life insurance
policies.  The Company invests in tax-advantaged sources of income to
reduce its overall tax burden.  However, as the Company continues to
increase the amount of income derived from interest income on loans and fee
income on loans and deposits, the effective tax rate is expected to increase.
During the first half of 2008 the Company’s income tax expense totaled $460,000,
or 20.1% of taxable income.


23





Liquidity





The
objectives of the Company’s liquidity management policy include providing
adequate funds to meet the cash needs of both borrowers and depositors, to
provide for the on-going operations of the Company, and to capitalize on
opportunities for expansion.  Liquidity management addresses the
Company’s ability to meet deposit withdrawals on demand or at contractual
maturity, to repay borrowings as they mature, and to fund new loans and
investments as opportunities arise.  The primary sources of internally
generated funds are principal and interest payments on loans receivable,
increases in local deposits, cash flows generated from operations, and cash
flows generated by investments.  If the Company requires funds beyond
its internal funding capabilities, it may rely upon external sources of funds
such as brokered deposits, repurchase agreements, and advances.  The
Company has $82.3 million available to draw from its line of credit with the
FHLB.  The FHLB functions as a central reserve bank providing credit
for member financial institutions. As a member of the FHLB, we are required to
own capital stock in the FHLB and we are authorized to apply for advances on the
security of such stock and certain of our mortgage loans and other assets
(principally securities that are obligations of, or guaranteed by, U.S.
Government Agencies, or Enterprises) provided certain creditworthiness standards
have been met. Advances are made pursuant to several different credit programs.
Each credit program has its own interest rate and range of maturities. Depending
on the program, limitations on the amount of advances are based on the financial
condition of the member institution and the adequacy of collateral pledged to
secure the credit.  The Company also has $16.0 million available from
an unsecured federal funds accommodation with Pacific Coast Bankers Bank
(“PCBB”).  PCBB is the Company’s primary correspondent bank. The
federal funds facility is for a term of 12 months and is used for the purpose of
providing daily liquidity as needed by the Company.  Outstanding
advances made under this facility are generally repaid on a daily basis at a
rate determined by PCBB based on their marginal cost of
funds.  Advances are limited to not more than 10 consecutive days at a
time.  The Company may also solicit brokered deposits for providing
funds for asset growth.  As of June 30, 2009, the Company had
outstanding brokered deposits of $99,000. The Company believes that it has
sufficient sources of liquidity to fund the cash needs of both borrowers and
depositors, to provide for the ongoing operations of the Company, and to
capitalize on opportunities for expansion.





In the
normal course of business, various commitments are outstanding that are not
reflected in the consolidated financial statements.  Commitments to
extend credit and undisbursed advances on customer lines of credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract.  The funding of these
commitments and previously approved undisbursed lines of credit could affect the
Company's liquidity position.  At June 30, 2009, the Company had loan
commitments of $27.1 million, unused lines of credit of $95.6 million, and
undisbursed construction loan proceeds of $1.4 million.  The Company
believes that it has adequate resources to fund loan commitments and lines of
credit as they arise.  The Company does not have any special purpose
entities or other similar forms of off-balance-sheet financing.





Capital
Resources





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


24





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





The Bank
is subject to various regulatory capital requirements administered by the
banking regulatory agencies. Failure to meet minimum capital requirements can
result in certain mandatory and possibly discretionary actions by the regulators
that, if undertaken, could have a direct material effect on the Bank’s financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank’s assets, liabilities,
and certain off-balance-sheet items as calculated under regulatory accounting
practices.  The Bank’s capital amounts and classifications are subject
to qualitative judgments by the regulators about components, risk-weightings,
and other factors.





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





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


25


ITEM
3.  Quantitative and Qualitative Disclosures About Market
Risk





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





ITEM
4.  Controls and Procedures





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





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





PART
II.  OTHER INFORMATION





Item
1.  Legal Proceedings





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





Item
1A.  Risk Factors





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


26


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




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




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




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





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





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





As of
June 30, 2009, the Company had repurchased a total of 3,213,911 shares, or 35.5%
of the outstanding shares of common stock, at an average price of
$13.06.  This stock was repurchased under a series of repurchase
programs that have been authorized by the Board of Directors over the past
several years.  The most recent repurchase authorization was granted
by the Board of Directors in June 2008, for the repurchase of up to 200,000
shares, or approximately 2.7% of the Company’s then outstanding shares of common
stock.  As of June 30, 2009, the Company had repurchased a total of
9,476 shares at an average price of $7.91 per share and had 190,524 shares
remaining to be repurchased under this plan.  On December 12, 2008,
the Company entered into a Letter Agreement with the U.S. Treasury pursuant to
which the Company has issued and sold to the U.S. Treasury: (i) 20,500 shares of
the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par
value $0.01 per share, having a liquidation amount per share equal to $1,000,
for a total price of $20,500,000 and (ii) a warrant to purchase 428,870 shares
of the Company's common stock, par value $0.01 per share, at an exercise price
per share of $7.17.  As a condition for issuing the preferred stock,
the U.S. Treasury limited the Company’s ability to repurchase common stock of
the Company and increase its dividend payments to stockholders without receiving
prior approval from the U.S. Treasury.   As a result, future
repurchases of Company common stock are not anticipated for 2009.





Item
3.  Defaults Upon Senior Securities





None.


27


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





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





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





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





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





For
                
                Against
                
                Abstain5,628,597
                
                267,413
                
                75,985





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





For
              
              Against
              
              Abstain5,952,805
              
              5,450
              
              13,740





Item
5.  Other Information





None.





Item
6.  Exhibits





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





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





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





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


28


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 CorporationDate:
      August 13, 2009
              By:
              /s/ Kim S. PriceKim
      S. PricePresident
      and Chief Executive OfficerDate:
      August 13, 2009
              By:
              /s/ Gary F. HoskinsGary
      F. HoskinsExecutive
      Vice President, Chief Financial Officerand
      Treasurer


29