SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





Annual
Report Pursuant to Section 13 or 15(d)


of
the Securities Exchange Act of 1934





For
the Fiscal Year Ended December 31,
2008





Commission
File No. 000-23971





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
                  
                  28054-4040(Address
      of principal executive offices)
                  
                  (Zip
      Code)





Registrant’s
telephone number, including area code (704)
868-5200





Securities
Registered Pursuant to Section 12(b) of the Act:





Common Stock, par value $0.01 per
      share
                  
                  The NASDAQ Stock Market,
  LLC(Title
      of Class)
                  
                  (Name
      of exchange on which
registered)





Securities
Registered Pursuant to Section 12(g) of the Act: None





Indicate
by check mark if the Registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act of 1933. YES  ̈   NO
x





Indicate
by check mark if the Registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Securities Exchange Act of
1934.  YES  ̈   NO
x





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 twelve months (or
for such shorter period that the Registrant was required to file such reports)
and (2) has been subject to such requirements for the past 90
days.  YES x   NO
 ̈.





Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of Registrant’s knowledge, in the
definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendments to this Form 10-K.  x.





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 definition of “large accelerated
filer,”  “accelerated filer,” and “smaller reporting company” in Rule
12b-2 of the Exchange Act.  (Check one):


Large
Accelerated Filer  ̈       Accelerated
Filer  ̈       Non-Accelerated
Filer  ̈       Smaller
reporting Company x





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


YES  ̈   NO
x





The
aggregate market value of the voting and non-voting common equity held by
non-affiliates of the Registrant, computed by reference to the last sale price
on June 30, 2008, as reported by the Nasdaq Global Market, was approximately
$49.3 million.





As of
March 13, 2009, there were 7,515,957 shares of the common stock, $0.01 par
value, outstanding.





DOCUMENTS INCORPORATED BY
REFERENCE





(1)           Proxy
Statement for the 2008 Annual Meeting of Stockholders of the Registrant (Part
III).













CITIZENS
SOUTH BANKING CORPORATION


AND
SUBSIDIARIES





FORM
10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008





TABLE
OF CONTENTS




PagePart
      IItem
      1.
                        Business
                        1Item
      1A.
                        Risk
      Factors
                        7Item
      1B.
                        Unresolved
      Staff Comments
                        10Item
      2.
                        Properties
                        11Item
      3.
                        Legal
      Proceedings
                        12Item
      4.
                        Submission
      of Matters to a Vote of Security Holders
                        12Part
      IIItem
      5.
                        Market
      for Registrant’s Common Stock, Related Stockholder Matters and
      Issuer Purchases of Equity Securities
                        12Item
      6.
                        Selected
      Financial Data
                        16Item
      7.
                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        17Item
      7A.
                        Quantitative
      and Qualitative Disclosures About Market Risk
                        41Item
      8.
                        Financial
      Statements and Supplementary Data
                        42Report
      of Independent Registered Public Accounting Firm
                        42Consolidated
      Statements of Financial Condition
                        43Consolidated
      Statements of Income
                        44Consolidated
      Statements of Comprehensive Income
                        45Consolidated
      Statements of Changes in Stockholders’ Equity
                        46Consolidated
      Statements of Cash Flows
                        47Notes
      to Consolidated Financial Statements
                        48Item
      9.
                        Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                        75Item
      9A.
                        Controls
      and Procedures
                        75Management’s
      Annual Report on Internal Control over Financial Reporting
                        75Item
      9B.
                        Other
      Information
                        76Part
      IIIItem
      10.
                        Directors,
      Executive Officers and Corporate Governance
                        76Item
      11.
                        Executive
      Compensation
                        76Item
      12.
                        Security
      Ownership of Certain Beneficial Owners and Management and Related
      Shareholder Matters
                        76Item
      13.
                        Certain
      Relationships, Related Transactions and Director
    Independence
                        76Item
      14.
                        Principal
      Accountant Fees and Services
                        76Part
      IVItem
      15.
                        Exhibits
      and Financial Statement Schedules
                        76Signatures










PART I





ITEM
      1.
            Business





Citizens
South Banking Corporation





Citizens
South Banking Corporation (also referred to as the “Company”, the “Registrant”,
"We", "Us", or "Our") is a Delaware corporation that owns all of the outstanding
shares of common stock of Citizens South Bank (the "Bank"). The shares of common
stock of the Company trade on the Nasdaq Global Market under the ticker symbol
“CSBC.”  The Company is a public company, and files interim,
quarterly, and annual reports with the SEC.  These respective reports
are on file and a matter of public record with the SEC and may be read and
copied at the SEC’s Public Reference Room at 450 Fifth Street NW, Washington, DC
20549.  The public may obtain information on the operation of the
Public Reference Room by calling the SEC at 1-800-SEC-0330.  The SEC
maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC at www.sec.gov.





The
Company’s principal business activities are overseeing and directing the
business of the Bank. The Company’s assets consist primarily of the outstanding
capital stock of the Bank, deposits held at the Bank, and investment
securities.  The Company became the holding company for the Bank on
September 30, 2002, in connection with the mutual-to-stock conversion of
Citizens South Holdings, MHC, the mutual holding company of Citizens South
Banking Corporation, a federal corporation, formerly named Gaston Federal
Bancorp, Inc., which was originally formed on March 18, 1998 for the purpose of
acting as the holding company for the Bank.





The
Company’s executive office is located at 519 South New Hope Road, P.O. Box 2249,
North Carolina 28053-2249 and its telephone number at this address is (704)
868-5200.  The Company also maintains a website at
www.citizenssouth.com that includes important information on our Company,
including a list of our products and services, branch locations, and current
financial information.  In addition, we make available, without
charge, through our website a link to our filings with the SEC, including copies
of annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K, and amendments to these filings, if any.  Information on
our website should not be considered a part of this annual report.





Citizens
South Bank





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, commissions earned from
the sale of uninsured investment products, 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, advertising, amortization of intangible assets 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.





As of December 31, 2008, Citizens South
Bank had 15 full-service branch offices in the North Carolina Counties of
Gaston, Union, Rowan, and Iredell and York County in South Carolina. The Bank’s
executive office is located at 519 South New Hope Road, P.O. Box 2249, Gastonia,
North Carolina 28053-2249. Its telephone number at this address is (704)
868-5200. The Bank also maintains a website at www.citizenssouth.com that
includes important information on our Bank, including a list of our products and
services and branch locations.


1


Market
Area and Competition





We
consider our primary market area to be the North Carolina Counties of Gaston,
Rowan, Iredell, Union, Mecklenburg, Cabarrus, Lincoln, and Cleveland, and the
South Carolina County of York.  Our market area predominately centers
in the suburbs surrounding the metropolitan area of Charlotte, North
Carolina.  The metropolitan area of Charlotte has a diverse economic
base that includes business sectors in banking and finance, insurance,
manufacturing, textiles, apparel, fabricated metals, construction, health care,
transportation, retail trade, telecommunications, government services, and
education. In 2008, the Charlotte metropolitan area experienced moderate
decreases in housing prices, an increased unemployment rate, decreased housing
starts and housing sales and decreased commercial activity.  However,
the economic slowdown in the Charlotte metropolitan area has generally been less
severe than the economic slowdown experienced in other large metropolitan areas
of the country.





The
Bank's corporate headquarters is located in Gastonia, North Carolina, which is
located approximately 20 miles west of Charlotte.  The Bank’s
corporate headquarters and seven of its branch offices are located in Gaston
County, North Carolina. These offices are located in the cities of Gastonia
(three offices), Dallas, Mount Holly, Belmont, and
Stanley.   According to data provided by the Federal Deposit
Insurance Corporation (“FDIC”) as of June 30, 2008, there were 15 banks and
thrifts operating in Gaston County with $2.3 billion in deposits.  As
of June 30, 2008, the Bank had $256.9 million in deposits in Gaston County, or
12.1% of the total county deposits.  This represents the third highest
deposit market share in Gaston County.





Two
branch offices are in Rowan County, North Carolina, in the cities of Salisbury
and Rockwell. According to data provided by the FDIC as of June 30, 2008, there
were 13 banks and thrifts operating in Rowan County with $1.5 billion in
deposits.  As of June 30, 2008, the Bank had $118.5 million in
deposits in Rowan County, or 8.0% of the total county deposits representing the
fourth highest market share in the county.





We also
have three branch offices in Union County, North Carolina, in the cities of
Monroe, Stallings, and Weddington. According to data provided by the FDIC as of
June 30, 2008, there were 11 banks and thrifts operating in Union County with
$1.6 billion in deposits.  As of June 30, 2008, the Bank had $105.9
million in deposits in Union County, or 6.6% of the total county
deposits.  This represents the seventh highest market share in the
county.





We have
two branch offices in Iredell County, North Carolina, in the cities of
Statesville and Mooresville. According to data provided by the FDIC as of June
30, 2008, there were 23 banks and thrifts operating in Iredell County with $2.1
billion in deposits.  As of June 30, 2008, the Bank had $95.4 million
in deposits in Iredell County, or 4.5% of the total county
deposits.  This represents the seventh highest market share in the
county.





In 2008,
we opened a branch office in Rock Hill, South Carolina, which is located in York
County, South Carolina.  According to data provided by the FDIC as of
June 30, 2008, there were 15 banks and thrifts operating in York County with
$2.0 billion in deposits.  As of June 30, 2008, the Bank had $10.8
million in deposits in York County.





Employees




As of
December 31, 2008, the Company had 127 full-time and 37 part-time employees,
none of whom is represented by a collective bargaining unit.  The
Company provides employee benefit programs, including an Employee Stock
Ownership Plan, matching contributions to a 401(k) retirement/savings plan,
group life, disability, heath, and dental insurance, and paid vacation and sick
leave. Management believes its working relationship with its employees is
good.




Subsidiaries




Citizens
South Banking Corporation is a unitary savings and loan holding company that
owns all of the outstanding stock of Citizens South Bank, a federally chartered
savings bank.  In addition, the Company has a wholly-owned subsidiary,
CSBC Statutory Trust I, which is used to issue trust preferred
securities.  These long term obligations qualify as tier I capital at
the Bank and represent a full and unconditional guarantee by the Company of the
trust’s obligations under the preferred securities.


2




Supervision
and Regulation





The
following discussion summarizes certain material elements of the regulatory
framework applicable to Citizens South Banking Corporation and its
subsidiaries.  These summaries of statutes and regulations are not
intended to be complete and such summaries are qualified in their entirety by
reference to such statutes and regulations.  A change in the statutes,
regulations, or regulatory policies applicable to the Company, or its
subsidiaries, could have a material effect on the business of the
Company.




General.Citizens
South Banking Corporation is subject to regulation and supervision by the Office
of Thrift Supervision (“OTS”).  The OTS has enforcement authority over
Citizens South Banking Corporation and its subsidiaries.  This
authority permits the OTS to restrict or prohibit activities that are determined
to be a risk to Citizens South Bank.





Citizens
South Bank is a federally chartered stock savings bank and derives its lending
and investment powers from the Home Owners’ Loan Act, as amended, and the
regulations of the OTS.  Under these laws and regulations, Citizens
South Bank may invest in mortgage loans secured by residential and commercial
real estate, commercial business and consumer loans, certain types of debt
securities and certain other assets.  Citizens South Bank also may
establish subsidiaries that may engage in activities not otherwise permissible
for Citizens South Bank, including real estate investment and securities and
insurance brokerage. Citizens South Bank is subject to examination, supervision,
and regulation by the OTS, as its primary federal regulator, and the FDIC, as
the deposit insurer.  Citizens South Bank is also a member of and owns
stock in the Federal Home Loan Bank of Atlanta, which is a part of the Federal
Home Loan Bank System.  The Bank must file reports with the OTS and
the FDIC concerning its activities and financial condition in addition to
obtaining regulatory approvals prior to entering into certain transactions such
as mergers or acquisitions. This regulation and supervision establishes a
comprehensive framework of activities in which an institution may engage and is
intended primarily for the protection of the insurance fund and depositors.
Under this system of federal regulation, financial institutions are periodically
examined to ensure that they satisfy applicable standards with respect to their
capital adequacy, assets, management, earnings, liquidity and sensitivity to
market interest rates. Citizens South Bank is also regulated to a lesser extent
by the Board of Governors of the Federal Reserve System, governing reserves to
be maintained against deposits and other matters.  Citizens South
Bank’s relationship with its depositors and borrowers also is regulated to a
great extent by both federal and state laws, especially in matters concerning
the ownership of deposit accounts and the form and content of Citizens South
Bank’s loan documents.





Standards for Safety and
Soundness.  Federal law
requires each federal banking agency to prescribe certain standards for all
insured depository institutions.  These standards relate to, among
other things, internal controls, information systems and audit systems, loan
documentation, credit underwriting, interest rate risk exposure, asset growth,
compensation, and other operational and managerial standards as the agency deems
appropriate.  If the appropriate federal banking agency determines
that an institution fails to meet any standard prescribed by the guidelines, the
agency may require the institution to submit to the agency an acceptable plan to
achieve compliance with the standard.  If an institution fails to meet
these standards, the appropriate federal banking agency may require the
institution to submit a compliance plan.  The OTS has primary
enforcement responsibility over federal savings institutions and has the
authority to bring enforcement action against all “institution-affiliated
parties,” including certain stockholders, and attorneys, appraisers and
accountants who knowingly or recklessly participate in wrongful action likely to
have an adverse effect on an insured institution.  Formal enforcement
action may range from the issuance of a capital directive, a cease and desist
order, removal of officers and/or directors of the institution, receivership,
conservatorship, civil penalties, or the termination of deposit
insurance.  The FDIC also has the authority to recommend to the
Director of the OTS that enforcement action be taken with respect to a
particular savings institution.  If action is not taken by the
Director, the FDIC has authority to take action under specified
circumstances.





Prompt Corrective
Action.Under prompt corrective action regulations, the OTS is
required and authorized to take supervisory actions against undercapitalized
savings banks. OTS regulations require savings banks to meet three minimum
capital standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio.  For this purpose, a savings bank is placed
in one of the following five categories based on the bank’s capital: 1)
well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and
10% total risk-based capital); 2) adequately capitalized (at least 4% leverage
capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3)
undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage
capital); and 5) critically undercapitalized (less than 2% tangible capital). At
December 31, 2008, Citizens South Bank met the criteria for being considered
“well-capitalized” for all three regulatory capital standards.


3


Capital
Distributions.OTSregulations govern
capital distributions by a federal savings bank, which include cash dividends,
stock repurchases and other transactions charged to the capital account. A
savings bank must file an application for approval of a capital distribution if:
(1) the total capital distributions for the applicable calendar year exceed the
sum of the savings bank’s net income for that year to date plus the savings
bank’s retained net income for the preceding two years; (2) the bank would not
be at least adequately capitalized following the distribution; (3) the
distribution would violate any applicable statute, regulation, agreement or
OTS-imposed condition; or (4) the savings bank is not eligible for expedited
treatment of its filings. Even if an application is not otherwise required,
every savings bank that is a subsidiary of a holding company must file a notice
with the OTS at least 30 days before the board of directors declares a dividend
or approves a capital distribution. The OTS may disapprove a notice or
application if: (1) the savings bank would be undercapitalized following the
distribution; (2) the proposed capital distribution raises safety and soundness
concerns; or (3) the capital distribution would violate a prohibition contained
in any statute, regulation or agreement.





Changes
in Control.Federal law prohibits a
savings and loan holding company from acquiring direct or indirect control of
another savings institution or holding company thereof, without prior written
approval of the OTS.  It also prohibits the acquisition or retention
of, with specified exceptions, more than 5% of the equity securities of a
company engaged in activities that are not closely related to banking or
financial in nature or acquiring or retaining control of an institution that is
not federally insured.  In evaluating applications by holding
companies to acquire savings institutions, the OTS must consider the financial
and managerial resources, future prospects of the savings institution involved,
the effect of the acquisition on the risk to the insurance fund, the convenience
and needs of the community and competitive factors.





Community Reinvestment Act and Fair
Lending Laws.All savings banks have a responsibility under the Community
Reinvestment Act and related regulations of the OTS to help meet the credit
needs of their communities, including low- and moderate-income
neighborhoods.  In connection with its examination of a federal
savings bank, the OTS is required to assess the savings bank’s record of
compliance with the Community Reinvestment Act.  In addition, the
Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from
discriminating in their lending practices on the basis of characteristics
specified in those statutes.  A bank’s failure to comply with the
provisions of the Community Reinvestment Act could, at a minimum, result in
regulatory restrictions on its activities. The failure to comply with the Equal
Credit Opportunity Act and the Fair Housing Act could result in enforcement
actions by the OTS, as well as other federal regulatory agencies and the
Department of Justice.  Citizens South Bank received a “Satisfactory”
Community Reinvestment Act rating in its most recent federal
examination.





Transactions with
Affiliates.  A federal savings bank’s authority to engage in
transactions with its “affiliates” is limited by OTS regulations and by Sections
23A and 23B of the Federal Reserve Act (the “FRA”) and its implementing
regulations.  The term “affiliates” for these purposes generally means
any company that controls or is under common control with an
institution.  Citizens South Banking Corporation and its subsidiaries
are affiliates of Citizens South Bank.  In general, transactions with
affiliates must be on terms that are as favorable to the savings bank as
comparable transactions with non-affiliates.  In addition, certain
types of these transactions are restricted to an aggregate percentage of the
savings bank’s capital.  Collateral in specified amounts must usually
be provided by affiliates in order to receive loans from the savings
bank.  In addition, OTS regulations prohibit a savings bank from
lending to any of its affiliates that are engaged in activities that are not
permissible for bank holding companies and from purchasing the securities of any
affiliate, other than a subsidiary.





Loans to
Insiders.Citizens South Bank’s authority to extend credit to
its directors, executive officers and 10% shareholders, as well as to entities
controlled by such persons, is currently governed by the requirements of
Sections 22(g) and 22(h) of the FRA and Regulation O of the Federal Reserve
Board. Among other things, these provisions require that extensions of credit to
insiders (i) be made on terms that are substantially the same as, and follow
credit underwriting procedures that are not less stringent than, those
prevailing for comparable transactions with unaffiliated persons and that do not
involve more than the normal risk of repayment or present other unfavorable
features, and (ii) not exceed certain limitations on the amount of credit
extended to such persons, individually and in the aggregate, which limits are
based, in part, on the amount of Citizens South Bank’s capital.  In
addition, extensions of credit in excess of certain limits must be approved by
Citizens South Bank’s Board of Directors.


4


Insurance of Deposit
Accounts.Citizens South Bank’s
deposits are insured up to applicable limits by the Deposit Insurance Fund of
the FDIC.  In October 2008, the FDIC temporarily increased the maximum
insurance coverage limit from $100,000 per separately insured depositor to
$250,000 per separately insured depositor.  Effective January 1, 2010,
the maximum limit will return to $100,000 per separately insured
depositor.  The maximum insurance coverage for self-directed
retirement accounts remained unchanged at $250,000 per separately insured
depositor.  The FDIC amended its risk-based deposit assessment system
in 2007 to enable the FDIC to more closely tie each financial institution’s
premiums with the risk it poses to the Deposit Insurance Fund under authority
granted by the Federal Deposit Insurance Reform Act of 2005.  Under
the new risk-based assessment system the FDIC evaluated the risk of each
financial institution based on three primary sources of information: 1) its
supervisory rating, 2) its regulatory capital ratios, and 3) its long-term debt
issuer rating, if the institution has one.  Assessment rates are
determined by the FDIC and currently range from five and seven cents for every
$100 of domestic deposits for the healthiest institutions to 43 cents for every
$100 of domestic deposits for the riskiest institutions.  The Bank was
assessed at an average rate of 5.8 basis points for 2008.  On February 27, 2009, the
Federal Deposit Insurance Corporation published a final rule raising the current
deposit insurance assessment rates to a range from 12 to 45 basis points
beginning April 1, 2009.  Additionally, the Federal Deposit Insurance
Corporation issued an interim final rule that would impose a special assessment
of up to 20 basis points on all insured deposits as of June 30, 2009, which
would be payable on September 30, 2009.Based on insured
deposits for the fourth quarter of 2008, this special assessment, if implemented
as proposed, would equal approximately $1.2 million which would have a
significant negative impact on the results of operations of the Company for
2009.





Insurance of deposits may
be terminated by the FDIC upon a finding that an institution has engaged in
unsafe or unsound practices, is in an unsafe or unsound condition to continue
operations or has violated any applicable law, regulation, rule, order or
condition imposed by the FDIC. We do not currently know of any practice,
condition or violation that might lead to termination of our deposit insurance.In 2007, the FDIC merged the Bank Insurance Fund (“BIF”) and the Savings
Association Insurance Fund (“SAIF”) into a single insurance fund called the
Deposit Insurance Fund.  As a result of the merger, the BIF and SAIF
were abolished.  The merger of the BIF and SAIF into the Deposit
Insurance Fund does not affect the authority of the Financing Corporation
(“FICO”) to impose and collect, with approval of the FDIC, assessments and
anticipated payments, insurance costs and custodial fees on bonds issued by the
FICO in the 1980’s to recapitalize the Federal Savings and Loan Insurance
Corporation.  The bonds issued by the FICO are due to mature in 2017
through 2019.  For the quarter ended December 31, 2008, the annualized
FICO assessment was equal to 1.14 basis points for each $100 in domestic
deposits maintained at an institution.





On
October 14, 2008, the FDIC announced a new program – the Temporary Liquidity
Guarantee Program.  This program has two components. One guarantees
newly issued senior unsecured debt of a participating organization, up to
certain limits established for each institution, issued between October 14, 2008
and June 30, 2009. The FDIC will pay the unpaid principal and interest on a
FDIC-guaranteed debt instrument upon the uncured failure of the participating
entity to make a timely payment of principal or interest in accordance with the
terms of the instrument.  The guarantee will remain in effect until
June 30, 2012. In return for the FDIC’s guarantee, participating institutions
will pay the FDIC a fee based on the amount and maturity of the debt. Citizens
South Banking Corporation and Citizens South Bank have opted not to participate
in this component of the Temporary Liquidity Guarantee Program.  The
other component of the program provides full federal deposit insurance coverage
for non-interest bearing transaction deposit accounts, regardless of dollar
amount, until December 31, 2009. An annualized 10 basis point assessment on
balances in noninterest-bearing transaction accounts that exceed the existing
deposit insurance limit of $250,000 will be assessed on a quarterly basis to
insured depository institutions that have not opted out of this component of the
Temporary Liquidity Guarantee Program.  Citizens South Bank opted to
participate in this component of the Temporary Liquidity Guarantee
Program.





U.S.
Treasury’s Troubled Asset Relief Program Capital Purchase
Program.The Emergency Economic Stabilization Act of 2008 was
enacted in October 2008 and provides the U.S. Secretary of the Treasury with
broad authority to implement certain actions to help restore stability and
liquidity to U.S. markets. One of the provisions resulting from the legislation
is the Troubled Asset Relief Program Capital Purchase Program (“CPP”), which
provides for direct equity investment in perpetual preferred stock by the U.S.
Treasury Department in qualified financial institutions. The program is
voluntary and requires an institution to comply with a number of restrictions
and provisions, including limits on executive compensation, stock redemptions
and declaration of dividends.  The CPP provides for a minimum
investment of one percent of total risk-weighted assets and a maximum investment
equal to the lesser of three percent of total risk-weighted assets or $25
billion. Participation in the program is not automatic and is subject to
approval by the U.S. Treasury Department.  Citizens South Banking
Corporation was approved for and is participating in the CPP.  The
details of our participation in the CPP are set forth in Item 7 of this annual
report under the heading “Overview of Financial Condition and Results of
Operations.”


5


Qualified Thrift Lender
Test.As a federal savings
bank, Citizens South Bank is subject to a qualified thrift lender, or “QTL,”
test.  Under the QTL test, Citizens South Bank must maintain at least
65% of its portfolio assets in qualified thrift investments in at least nine
months of the most recent 12-month period.  Portfolio assets generally
means total assets of a savings institution, less the sum of specified liquid
assets up to 20% of total assets, goodwill and other intangible assets, and the
value of property used in the conduct of the savings bank’s business. Qualified
thrift investments includes various types of loans made for residential and
housing purposes, investments related to such purposes, including certain
mortgage-backed and related securities, and loans for personal, family,
household and certain other purposes up to a limit of 20% of portfolio
assets.  Qualified thrift investments also include 100% of an
institution’s credit card loans, education loans and small business
loans.  Citizens South Bank also may satisfy the QTL test by
qualifying as a “domestic building and loan association” as defined in the
Internal Revenue Code of 1986.  A savings bank that fails the
qualified thrift lender test must either convert to a bank charter or operate
under specified restrictions.  At December 31, 2008, Citizens South
Bank maintained approximately 78% of its portfolio assets in qualified thrift
investments and satisfied the QTL test as of that date.





Federal Home Loan Bank
System.  Citizens South Bank is a member of the Federal Home
Loan Bank System (“FHLB”), which provides a central credit facility primarily
for member institutions.  As a member of the FHLB of Atlanta, Citizens
South Bank is required to acquire and hold shares of capital stock in the FHLB
in an amount at least equal to 1% of the aggregate principal amount of its
unpaid residential mortgage loans and similar obligations at the beginning of
each year, or 1/20 of its borrowings from the FHLB, whichever is
greater.  As of December 31, 2008, Citizens South Bank was in
compliance with this requirement.





Federal Reserve System.The
Federal Reserve Board regulations require savings banks to maintain reserves
against their transaction accounts, such as negotiable order of withdrawal and
regular checking accounts.  At December 31, 2008, Citizens South Bank
was in compliance with these reserve requirements.  The balances
maintained to meet the reserve requirements imposed by the Federal Reserve Board
may be used to satisfy liquidity requirements imposed by the OTS.





USA PATRIOT Act of
2001.The USA PATRIOT Act of 2001 gives the federal government
new powers to address terrorist threats through enhanced domestic security
measures, expanded surveillance powers, increased information sharing and
broadened anti-money laundering requirements.  The USA PATRIOT Act
also requires the federal banking agencies to take into consideration the
effectiveness of controls designed to combat money laundering activities in
determining whether to approve a merger or other acquisition application of a
member institution.  Accordingly, if we engage in a merger or other
acquisition, our controls designed to combat money laundering would be
considered as part of the application process.  We have established
policies, procedures and systems designed to comply with these
regulations.





Sarbanes-Oxley Act of 2002.The Sarbanes-Oxley Act of 2002 addresses, among other issues, corporate
governance, auditing and accounting, executive compensation, and enhanced and
timely disclosure of corporate information. As directed by the Sarbanes-Oxley
Act, the Company’s Chief Executive Officer and Chief Financial Officer are
required to certify that its quarterly and annual reports do not contain any
untrue statement of a material fact. The rules adopted by the Securities and
Exchange Commission under the Sarbanes-Oxley Act have several requirements,
including having these officers certify that: they are responsible for
establishing, maintaining and regularly evaluating the effectiveness of the
Company’s internal control over financial reporting; they have made certain
disclosures to the Company’s auditors and the audit committee of the Board of
Directors about the Company’s internal control over financial reporting; and
they have included information in the Company’s quarterly and annual reports
about their evaluation and whether there have been changes in its internal
control over financial reporting or in other factors that could materially
affect internal control over financial reporting.


6


Federal Securities
Laws.  Citizens South Banking Corporation common stock is
registered with the Securities and Exchange Commission under the Securities
Exchange Act of 1934. Citizens South Banking Corporation is subject to the
information, proxy solicitation, insider trading restrictions and other
requirements under the Securities Exchange Act of 1934. Shares of common stock
purchased by persons who are not affiliates of Citizens South Banking
Corporation may be resold without registration. Shares purchased by an affiliate
of Citizens South Banking Corporation will be subject to the resale restrictions
of Rule 144 under the Securities Act of 1933. If Citizens South Banking
Corporation meets the current public information requirements of Rule 144 under
the Securities Act of 1933, each affiliate of Citizens South Banking Corporation
that complies with the other conditions of Rule 144, including those that
require the affiliate’s sale to be aggregated with those of other persons, would
be able to sell in the public market, without registration, a number of shares
not to exceed, in any three-month period, the greater of 1% of the outstanding
shares of Citizens South Banking Corporation, or 25% of the average weekly
volume of trading in the shares during the preceding four calendar
weeks.  In the future, Citizens South Banking Corporation may permit
affiliates to have their shares registered for sale under the Securities Act of
1933.





Taxation





Federal.The Company and the
Bank are subject to the provisions of the Internal Revenue Code of 1986, as
amended (the “Code”) in the same general manner as other
corporations.  For federal income tax purposes, the Bank reports its
income and expenses on the accrual method of accounting and uses a tax year
ending December 31 for filing its federal income tax returns.





The Small
Business Protection Act of 1996 (the “1996 Act”) eliminated the use of the
reserve method of accounting for bad debt reserves by savings institutions,
effective for taxable years beginning after 1995.  Prior to the 1996
Act, the Bank was permitted to establish a reserve for bad debts and to make
annual additions to the reserve.





State of North Carolina.  Under North
Carolina law, the corporate income tax is 6.9% of federal taxable income as
computed under the Code, subject to certain prescribed
adjustments.  In addition, an annual state franchise tax is imposed at
a rate of 0.15% applied to the greatest of the Company’s capital stock, surplus
and undivided profits, investment in tangible property in North Carolina or 55%
of the appraised valuation of property in North Carolina.





State of
Delaware.Delaware franchise taxes are imposed on the
Company.  Two methods are provided for calculating the tax and the
lesser tax is payable.  The first method is based on the authorized
number of shares.  The tax under this method is $90.00 for the first
10,000 authorized shares plus $50.00 for each additional 10,000 authorized
shares or part thereof.  The second method is based on an assumed par
value capital.  The tax rate under this method is $200 per $1,000,000
or portion thereof of assumed par value capital.  Assumed par is
computed by dividing total assets by total issued shares (including treasury
shares).  Assumed par value capital is calculated by multiplying the
lesser of assumed par or stated par value by total authorized
shares.





ITEM
      1A.
            Risk
      Factors





An
investment in our common stock involves risk. You should carefully consider the
risks described below and all other information contained in this annual report
on Form 10-K before you decide to buy our common stock.  It is
possible that risks and uncertainties not listed below may arise or become
material in the future and affect our business.





The United States economy is in
recession. A prolonged economic downturn, especially one affecting our
geographic market area, could materially and adversely affect our business and
financial results.  The United States economy entered a
recession in the fourth quarter of 2007.  Throughout the course of
2008 and in the first quarter of 2009, economic conditions continued to worsen,
due in large part to the fallout from the collapse of the sub-prime mortgage
market. While we did not originate or invest in sub-prime mortgages, our lending
business is tied, in large part, to the housing market.  Declines in
home prices, increases in foreclosures and higher unemployment have adversely
affected the credit performance of our real estate-related loans, resulting in
the write-down of asset values. The continuing housing slump also has resulted
in reduced demand for the construction of new housing, further declines in home
prices, and increased delinquencies on our construction, residential and
commercial mortgage loans. Further, the ongoing concern about the stability of
the financial markets in general has caused many lenders to reduce or cease
providing funding to borrowers. These conditions may also cause a further
reduction in loan demand, and increases in our non-performing assets, net
charge-offs and provisions for loan losses.


7


Changes
in interest rates could adversely affect the Company’s financial condition and
results of operations. Citizens
South Banking Corporation’s results of operations and financial condition are
affected by changes in interest rates. The Company’s results of operations
depend substantially on net interest income, which is the difference between the
interest income earned on interest-earning assets and the interest expense paid
on interest-bearing liabilities.  Because interest-earning assets
generally reprice or mature more quickly than interest-bearing liabilities, a
decrease in interest rates generally would result in a decrease in the Company’s
net interest income.  Based on results generated by its interest rate
risk model at December 31, 2008, a hypothetical, immediate and sustained
decrease of 300 basis points throughout the yield curve would decrease its
annual net interest income by 5.8%.  The assumptions used in the model
do not provide for actions that may be taken by management during the period to
offset the effects of changes in interest rates on net interest income. We are
also subject to reinvestment risk associated with changes in interest rates.
Changes in interest rates may affect the average life of loans and
mortgage-related securities. Decreases in interest rates can result in increased
prepayments of loans and mortgage-related securities, as borrowers refinance to
reduce borrowing costs. Under these circumstances, the Company is subject to
reinvestment risk to the extent that it is unable to reinvest the cash received
from such prepayments at rates that are comparable to the rates on existing
loans and securities.  Additionally, increases in interest rates may
decrease loan demand and make it more difficult for borrowers to repay
adjustable rate loans.





Changes
in interest rates also affect the value of Citizens South Banking Corporation’s
interest-earning assets, and in particular its securities
portfolio.  Generally, the value of securities fluctuates inversely
with changes in interest rates. At December 31, 2008, the Company’s investment
and mortgage-backed securities available for sale totaled
$109.2 million.  Unrealized gains on securities available for
sale, net of tax, amounted to $25,000 and are reported as a separate component
of stockholders’ equity. Decreases in the fair value of securities available for
sale, therefore, could have an adverse effect on stockholders’
equity.




The slowdown in our local economy
could impair the ability of our customers to repay their loans.We have
added a significant number of loans over the past five years from new
relationships as we have entered new markets through acquisitions and de novo
offices.  As a result, our loan portfolio may not be as seasoned as
the loan portfolios of our competitors in some of these new markets. Should
local real estate markets or economies continue to weaken, we will likely
experience higher default rates resulting in increased levels of non-performing
loans, which would likely result in higher loan losses and reduced
earnings.





The Company’s commercial real estate
loan portfolio could expose the Company to increased lending risks.At
December 31, 2008, Citizens South Banking Corporation’s portfolio of commercial
real estate, multifamily, and construction loans totaled $393.1 million, or
62.7% of total gross loans. These types of loans generally expose a lender to
greater risk of non-payment and loss than one-to-four family residential
mortgage loans because repayment of the loans often depends on the successful
operations and the income stream of the borrowers.  Such loans
typically involve larger loan balances to single borrowers or groups of related
borrowers compared to one-to-four family residential mortgage
loans.  Also, many of the Company’s borrowers have more than one
commercial loan outstanding.  Consequently, an adverse development
with respect to one loan or one credit relationship can expose the Company to a
significantly greater risk of loss compared to an adverse development with
respect to a one-to-four family residential mortgage loan.





Further declines in the value of
certain investment securities could require write-downs, which would reduce our
earnings.At December 31, 2008, our investment portfolio included a $1.0
million trust preferred collateralized debt obligation.  During 2008,
we recognized a $468,000 charge for the other-than-temporary impairment of the
trust preferred security.  A number of factors or combinations of
factors could cause us to conclude in one or more future reporting periods that
an unrealized loss that exists with respect to these securities constitutes an
impairment that is other than temporary. These factors include, but are not
limited to, failure to make scheduled interest payments, an increase in the
severity of the unrealized loss on a particular security, an increase in the
continuous duration of the unrealized loss without an improvement in value or
changes in market conditions and/or industry or issuer specific factors that
would render us unable to forecast a full recovery in value. An
other-than-temporary impairment write-down would reduce our
earnings.


8


Strong competition within our market
areas may limit our growth and profitability.We face numerous
competitors in both our community banking and mortgage banking operations in the
Charlotte, North Carolina metropolitan area, which is our primary market
area.  We compete for loan and deposit growth with large banks that
have a regional or a national presence, other community banks, de novofinancial
institutions, thrifts or savings institutions, credit unions, brokerage and
insurance firms, and other nonbank businesses, such as retailers that engage in
consumer financing activities. Price competition for loans and deposits might
result in earning less on our loans and paying more on our deposits, which would
reduce our net interest income. Competition also makes it more challenging to
grow loans and deposits and to hire and retain experienced employees. Some of
the institutions with which we compete have substantially greater resources and
lending limits than we do and may offer services that we do not
provide.





If the Company’s allowance for loan
losses is not sufficient to cover actual loan losses, then our earnings could
decrease.We make various assumptions and judgments about the
collectability of our loan portfolio, including the creditworthiness of our
borrowers and the value of the real estate and other assets serving as
collateral for the repayment of many of our loans. In determining the amount of
allowance for loan losses, we review our loan loss and delinquency experience,
we evaluate current local economic conditions, and we analyze the collateral
position of our loan portfolio.  If our assumptions are incorrect, our
allowance for loan losses may not be sufficient to cover losses inherent in our
loan portfolio, resulting in increases to our allowance. Material additions to
our allowance would materially decrease our net income.  In addition,
federal regulators periodically review our allowance for loan losses and may
require us to increase our provision for loan losses or recognize additional
loan charge-offs. Any increase in our allowance for loan losses or loan
charge-offs as required by these regulatory authorities could have a material
adverse effect on our financial condition and results of
operations.





Future legislative or regulatory
actions responding to financial and market weakness could affect us
adversely. There can be no assurance that actions of the U.S.
Government, Federal Reserve and other governmental and regulatory bodies for the
purpose of stabilizing the financial markets will achieve the intended
effect.  In response to the financial crises affecting the banking
system and financial markets, the U.S. Congress has passed legislation and the
U.S. Treasury has promulgated programs designed to purchase assets from, provide
equity capital to, and guarantee the liquidity of the financial services
industry.  Specifically, Congress adopted the Emergency Economic
Stabilization Act of 2008, under which the U.S. Treasury has the authority to
expend up to $700 billion to assist in stabilizing and providing liquidity to
the U.S. financial system.  On October 14, 2008, the U.S.
Treasury announced the Capital Purchase Program, under which it will purchase up
to $250 billion of non-voting senior preferred shares of certain qualified
financial institutions in an attempt to encourage financial institutions to
build capital to increase the flow of financing to businesses and consumers and
to support the economy.  In addition, Congress temporarily increased
FDIC deposit insurance from $100,000 to $250,000 per depositor through
December 31, 2009.  The FDIC has also announced the creation of
the Temporary Liquidity Guarantee Program which is intended to strengthen
confidence and encourage liquidity in financial institutions by temporarily
guaranteeing newly issued senior unsecured debt of participating organizations
and providing full insurance coverage for noninterest-bearing transaction
deposit accounts (such as business checking accounts, interest-bearing
transaction accounts paying 50 basis points or less and lawyers’ trust
accounts), regardless of dollar amount until December 31,
2009.   Finally, in February 2009, the American Recovery and
Reinvestment Act of 2009 was enacted, which is intended to expand and establish
government spending programs and provide certain tax cuts to stimulate the
economy.  The U.S. Government continues to evaluate and develop
various programs and initiatives designed to stabilize the financial and housing
markets and stimulate the economy, including the U.S. Treasury’s recently
announced Financial Stability Plan and the recently announced foreclosure
prevention program.





The
potential exists for additional federal or state laws and regulations regarding
lending and funding practices and liquidity standards, and bank regulatory
agencies are expected to be active in responding to concerns and trends
identified in examinations, and the issuance of many formal enforcement orders
is expected.  Actions taken to date, as well as potential actions, may
not have the beneficial effects that are intended, particularly with respect to
the extreme levels of volatility and limited credit availability currently being
experienced.  In addition, new laws, regulations, and other regulatory
changes will increase our costs of regulatory compliance and of doing business,
and otherwise affect our operations.  Our FDIC insurance premiums have
increased, and may continue to increase, because market developments have
significantly depleted the insurance fund of the FDIC and reduced the ratio of
reserves to insured deposits. New laws, regulations, and other regulatory
changes, along with negative developments in the financial services industry and
the credit markets, may significantly affect the markets in which we do
business, the markets for and value of our loans and investments, and our
ongoing operations, costs and profitability.


9


Our wholesale funding sources may
prove insufficient to replace deposits at maturity and support our future
growth.We must maintain sufficient funds to respond to the
needs of depositors and borrowers. As a part of our liquidity management, we use
a number of funding sources in addition to core deposit growth and repayments
and maturities of loans and investments.  As we continue to grow, we
are likely to become more dependent on these sources, which include Federal Home
Loan Bank advances, proceeds from the sale of loans and liquidity resources of
the holding company.  At December 31, 2008, we had approximately $73.6
million of FHLB advances outstanding.  Our financial flexibility will
be severely constrained if we are unable to maintain our access to funding or if
adequate financing is not available to accommodate future growth at acceptable
interest rates. Finally, if we are required to rely more heavily on more
expensive funding sources to support future growth, our revenues may not
increase proportionately to cover our costs. In this case, our operating margins
and profitability would be adversely affected.





Various factors may make takeover
attempts more difficult to achieve.  Provisions of the
Company’s certificate of incorporation and bylaws, federal regulations, Delaware
law and various other factors may make it more difficult for companies or
persons to acquire control of Citizens South Banking Corporation without the
consent of its Board of Directors.  As a Citizens South Banking
Corporation stockholder, you may want a takeover attempt to succeed because, for
example, a potential acquirer could offer a premium over the then-prevailing
price of Citizens South Banking Corporation’s common stock.  The
factors that may discourage takeover attempts or make them more difficult
include:





Certificate of
incorporation and statutory provisions.Provisions of the
certificate of incorporation and bylaws of Citizens South Banking Corporation
and Delaware law may make it more difficult and expensive to pursue a takeover
attempt that management opposes.  These provisions also would make it
more difficult to remove Citizens South Banking Corporation’s current Board of
Directors or management, or to elect new directors.  These provisions
include limitations on voting rights of beneficial owners of more than 10% of
its common stock, supermajority voting requirements for certain business
combinations and the election of directors to staggered terms of three
years.  Citizens South Banking Corporation’s bylaws also contain
provisions regarding the timing and content of stockholder proposals and
nominations and qualification for service on the Board of
Directors.





Required change
in control payments and issuance of stock options and recognition plan
shares.  Citizens South
Banking Corporation has entered into employment agreements and change of control
agreements with certain executive officers, which will require payments to be
made to them in the event their employment is terminated following a change in
control of Citizens South Banking Corporation or Citizens South
Bank.  Citizens South Banking Corporation also has adopted plans to
permit additional issuances of stock options and recognition plan shares to key
employees and directors that will require payments to them in connection with a
change in control of Citizens South Banking Corporation.  These
payments will have the effect of increasing the costs of acquiring Citizens
South Banking Corporation, thereby discouraging future takeover
attempts.





Citizens South Banking Corporation’s
stock-based benefit plans may dilute your ownership
interest.  Citizens South Banking Corporation has adopted stock
option plans and recognition and retention plans. These stock-based benefit
plans can be funded from the issuance of authorized but unissued shares of
common stock or through open market purchases by the Company, subject to
approval by the U.S. Treasury Department.  Stockholders will
experience a reduction or dilution in ownership interest in the event newly
issued shares, instead of repurchased shares, are used to fund stock option
exercises and stock awards.





ITEM
      1.B.
            Unresolved
      Staff Comments





None.


10


ITEM
      2.
            Properties





The
following table sets forth certain information regarding full-service branch
offices currently in operation at December 31, 2008.  Management
considers the facilities to be well maintained and sufficiently suitable for
present operations.   The net book value of the properties,
including land, building, and leasehold improvements, net of accumulated
depreciation, was $16.8 million at December 31, 2008.


Approximate
                        
                        OwnedLocation
                        
                        Principal Use
                        
                        Facility Size
                        
                        or Leased(square feet)519
      South New Hope Road
                        
                        Banking
      Office and
                        
                        22,400
                        
                        OwnedGastonia,
      North Carolina 28054-4040
                        
                        Corporate
      Headquarters245
      West Main Avenue
                        
                        Banking
      Office and
                        
                        12,400
                        
                        OwnedGastonia,
      North Carolina 28052-4140
                        
                        Operations
      Center1670
      Neal Hawkins Road
                        
                        Banking
      Office and
                        
                        5,320
                        
                        OwnedGastonia,
      North Carolina 28056-6429
                        
                        Mortgage
      Center192
      East Woodrow Avenue
                        
                        Banking
      Office
                        
                        3,400
                        
                        OwnedBelmont,
      North Carolina 28012-3163233
      South Main Street
                        
                        Banking
      Office
                        
                        2,370
                        
                        OwnedMount
      Holly, North Carolina 28120-16203135
      Dallas High Shoals Highway
                        
                        Banking
      Office
                        
                        3,225
                        
                        OwnedDallas,
      North Carolina 28034-1307412
      South Highway 27
                        
                        Banking
      Office
                        
                        3,225
                        
                        OwnedStanley,
      North Carolina 28164-2055401
      West Innes Street
                        
                        Banking
      Office and
                        
                        5,560
                        
                        OwnedSalisbury,
      North Carolina 28144-4232
                        
                        Leased
      Office Space106
      West Main Street
                        
                        Banking
      Office
                        
                        1,500
                        
                        OwnedRockwell,
      North Carolina 28138-8859307
      North Center Street
                        
                        Banking
      Office and
                        
                        8,260
                        
                        OwnedStatesville,
      North Carolina 28677-4063
                        
                        Leased
      Office Space310
      West Franklin Street
                        
                        Banking
      Office
                        
                        4,692
                        
                        LeasedMonroe,
      North Carolina 28112-470413731
      Providence Road
                        
                        Banking
      Office
                        
                        2,520
                        
                        OwnedWeddington,
      North Carolina 28104-8615101
      Stallings Road
                        
                        Banking
      Office
                        
                        3,560
                        
                        LeasedStallings,
      North Carolina 28104-5065649
      Brawley School Road
                        
                        Banking
      Office
                        
                        3,800
                        
                        OwnedMooresville,
      North Carolina 28177-91212215
      India Hook Road
                        
                        Banking
      Office
                        
                        4,244
                        
                        LeasedRock
      Hill, South Carolina 29732-1223


11


ITEM
      3.
            Legal
      Proceedings





Periodically,
there have been various claims and lawsuits involving the Company or the Bank,
such as claims to enforce liens, condemnation proceedings on properties in which
we hold security interests, claims involving the making and servicing of real
property loans and other issues incident to our business. We are not a party to
any pending legal proceedings that we believe would have a material adverse
effect on the financial condition, operations, or cash flows of the Company or
the Bank.





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





No matters were submitted to a vote of
the security holders during the fourth quarter of 2008.





PART II





ITEM
5. Market
for Registrant's Common Stock, Related Stockholder Matters and Issuer Purchases
of Equity
Securities





a.The Company’s
common stock, $0.01 par value per share, trades on the Nasdaq Global Market
under the ticker symbol CSBC. Price and volume information is contained in The Wall Street Journaland other
daily newspapers in the Nasdaq section under the Global Market System listings.
As of February 1, 2009, the Company had 1,592 stockholders of record (excluding
the number of persons or entities holding stock in street name through various
brokerage firms), and 7,515,957 shares outstanding. The following brokers made a
market in the Company’s stock during 2008:





Citadel
      Derivatives Group, LLC
                1-312-395-2010Fig
      Partners, LLC
                1-404-601-7200Friedman,
      Billings, Ramsey & Co.
                1-800-688-3272Howe
      Barnes Investments, Inc.
                1-800-621-2364Hudson
      Securities, Inc.
                1-800-624-0050Janney
      Montgomery Scott LLC
                1-215-563-8672Keefe,
      Bruyette & Woods, Inc.
                1-800-342-5529Knight
      Equity Markets, L.P.
                1-800-222-4910Merrill
      Lynch, Pierce, Fenner
                1-800-937-0501Morgan
      Keegan & Co., Inc.
                1-800-238-7533Morgan
      Stanley & Co., Inc.
                1-800-223-6559Sandler
      O’Neill & Partners
                1-212-466-8020Stanford
      Group Company
                1-212-492-8244Sterne,
      Agee & Leach
                1-800-239-2408Stifel
      Nicolaus and Co., Inc.
                1-800-776-6821Susquehanna
      Financial Group
                1-800-825-9550Timber
      Hill, Inc.
                1-203-618-5841UBS
      Securities LLC
                1-203-719-7400


12


The
following table sets forth quarterly market sales price ranges, dividend
information, and repurchase activity for the Company’s common stock over the
past two years.





2008
                        
                        Quarter 1
                        
                        
                        Quarter 2
                        
                        
                        Quarter 3
                        
                        
                        Quarter 4Price
      Range:High
                        
                        $
                        11.03
                        
                        
                        $
                        10.06
                        
                        
                        $
                        8.24
                        
                        
                        $
                        7.90Low
                        
                        
                        9.21
                        
                        
                        
                        7.42
                        
                        
                        
                        7.03
                        
                        
                        
                        5.75Dividend
                        
                        
                        0.085
                        
                        
                        
                        0.085
                        
                        
                        
                        0.085
                        
                        
                        
                        0.085Shares
      Repurchased
                        
                        
                        67,000
                        
                        
                        
                        28,628
                        
                        
                        
                        7,200
                        
                        
                        
                        -Avg.
      Price Paid Per Share
                        
                        $
                        10.06
                        
                        
                        
                        9.00
                        
                        
                        $
                        7.95
                        
                        
                        $
                        0.00





2007
                      
                      Quarter 1
                      
                      
                      Quarter 2
                      
                      
                      Quarter 3
                      
                      
                      Quarter 4Price
      Range:High
                      
                      $
                      13.40
                      
                      
                      $
                      13.00
                      
                      
                      $
                      12.99
                      
                      
                      $
                      12.33Low
                      
                      
                      12.13
                      
                      
                      
                      12.38
                      
                      
                      
                      12.09
                      
                      
                      
                      9.72Dividend
                      
                      
                      0.08
                      
                      
                      
                      0.08
                      
                      
                      
                      0.08
                      
                      
                      
                      0.08Shares
      Repurchased
                      
                      
                      114,712
                      
                      
                      
                      121,000
                      
                      
                      
                      116,725
                      
                      
                      
                      163,200Avg.
      Price Paid Per Share
                      
                      $
                      13.09
                      
                      
                      
                      12.88
                      
                      
                      $
                      12.73
                      
                      
                      $
                      11.76





The
Company’s dividend payout ratio was 81% in 2008, compared to 43% in
2007.  The Company has paid a cash dividend each year since converting
from a mutual to stock form of ownership.  In addition, the Company
has increased its cash dividend each year since its initial public
offering.  However, as a condition to participating in the U.S.
Treasury Capital Purchase Plan, the Company may no longer increase dividend
payments made to common stockholders without receiving prior approval from the
U.S. Treasury.   As a result, future dividend increases to common
stockholders are not anticipated for 2009.  In addition, the Board of
Directors may decide to reduce or eliminate future dividend payments to common
stockholders based on the direction of the Company’s future capital position,
net income, credit quality and other factors.


13


Performance
Graph





The
following is a stock performance graph comparing (a) the cumulative total return
on the common stock for the period beginning with the last trade of Citizens
South Banking Corporation’s stock on December 31, 2003, as reported on the
Nasdaq Stock Market, through December 31, 2008, (b) the cumulative total return
on stocks included in the Russell 2000 index over such period, and (c) the
cumulative total return on stocks included in the SNL Southeast Thrift Index
over such period.  Cumulative return assumes the reinvestment of
dividends, and is expressed in dollars based on an assumed initial investment of
$100.  The performance graph was prepared by SNL Financial, LC using
data as of December 31, 2008.


Citizens
South Banking Corporation











Period
      EndingIndex
                            
                            12/31/03
                            
                            
                            12/31/04
                            
                            
                            12/31/05
                            
                            
                            12/31/06
                            
                            
                            12/31/07
                            
                            
                            12/31/08Citizens
      South Banking Corporation
                            
                            
                            100.00
                            
                            
                            
                            104.30
                            
                            
                            
                            89.23
                            
                            
                            
                            98.92
                            
                            
                            
                            79.39
                            
                            
                            
                            48.82Russell
      2000
                            
                            
                            100.00
                            
                            
                            
                            118.33
                            
                            
                            
                            123.72
                            
                            
                            
                            146.44
                            
                            
                            
                            144.15
                            
                            
                            
                            95.44SNL
      Southwest Thrift Index
                            
                            
                            100.00
                            
                            
                            
                            104.16
                            
                            
                            
                            107.12
                            
                            
                            
                            131.30
                            
                            
                            
                            89.63
                            
                            
                            
                            43.63





There can
be no assurance that the common stock’s performance will continue in the future
with the same or similar trend depicted in the graph.  Citizens South
Banking Corporation will not make or endorse any predictions as to future
performance.


14


b.  Not
applicable.





c.During the
three-month period ended December 31, 2008, the Company repurchased the
following shares of common stock.





2008
                
                Total
                  Number of
                  Shares
                  Purchased
                
                
                Average
                  Price Paid
                  per Share
                
                
                Total Number of Shares
                  Purchased as Part of
                  Publicly Announced Plan
                
                
                Maximum Number of
                  Shares that May be
                  Purchased Under the PlanOctober
                
                
                0
                
                
                $
                0.00
                
                
                
                9,476
                
                
                
                190,524November
                
                
                0
                
                
                $
                0.00
                
                
                
                9,476
                
                
                
                190,524December
                
                
                0
                
                
                $
                0.00
                
                
                
                9,476
                
                
                
                190,524Total
                
                
                0
                
                
                $
                0.00
                
                
                
                9,476
                
                
                
                190,524





As of
December 31, 2008, 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. 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 among other factors. As of December 31,
2008, 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, Citizens South Banking Corporation
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, the U.S. Treasury department limited
the Company’s ability to repurchase common stock of the Company and increase its
dividend payments to shareholders without receiving prior approval from the U.S.
Treasury.   As a result, future repurchases of Company common
stock are not anticipated for 2009.


15


ITEM
      6.
            Selected
      Financial Data





The
following table sets forth certain information concerning the financial position
of Citizens South Banking Corporation and its subsidiaries as of and for the
dates indicated.  The consolidated data is derived from, and should be
read in conjunction with the Consolidated Financial Statements of the Company
and its subsidiaries and related notes presented in Item 8.  The
information for the years ended December 31, 2005 and 2004 is derived in part
from financial statements that do not appear in this annual report.




At and for the years ended December
      31,2008 (1)
                                  
                                  
                                  2007 (1)
                                  
                                  
                                  2006 (1)
                                  
                                  
                                  2005 (1)
                                  
                                  
                                  2004(Dollars
      in Thousands, Except per Share Data)Income
      Statement Data:Interest
      income
                                  
                                  $
                                  42,608
                                  
                                  
                                  $
                                  46,735
                                  
                                  
                                  $
                                  42,919
                                  
                                  
                                  $
                                  26,948
                                  
                                  
                                  $
                                  21,110Interest
      expense
                                  
                                  
                                  22,406
                                  
                                  
                                  
                                  26,500
                                  
                                  
                                  
                                  22,279
                                  
                                  
                                  
                                  11,469
                                  
                                  
                                  
                                  7,943Net
      interest income
                                  
                                  
                                  20,202
                                  
                                  
                                  
                                  20,235
                                  
                                  
                                  
                                  20,640
                                  
                                  
                                  
                                  15,479
                                  
                                  
                                  
                                  13,167Provision
      for loan losses
                                  
                                  
                                  3,275
                                  
                                  
                                  
                                  1,290
                                  
                                  
                                  
                                  1,165
                                  
                                  
                                  
                                  985
                                  
                                  
                                  
                                  330Net
      interest income after provision for loan losses
                                  
                                  
                                  16,927
                                  
                                  
                                  
                                  18,945
                                  
                                  
                                  
                                  19,475
                                  
                                  
                                  
                                  14,494
                                  
                                  
                                  
                                  12,837Noninterest
      income
                                  
                                  
                                  6,019
                                  
                                  
                                  
                                  6,562
                                  
                                  
                                  
                                  6,141
                                  
                                  
                                  
                                  4,441
                                  
                                  
                                  
                                  4,824Noninterest
      expense
                                  
                                  
                                  19,226
                                  
                                  
                                  
                                  17,895
                                  
                                  
                                  
                                  17,544
                                  
                                  
                                  
                                  14,339
                                  
                                  
                                  
                                  13,629Income
      before income taxes
                                  
                                  
                                  3,720
                                  
                                  
                                  
                                  7,612
                                  
                                  
                                  
                                  8,072
                                  
                                  
                                  
                                  4,596
                                  
                                  
                                  
                                  4,032Income
      tax expense
                                  
                                  
                                  639
                                  
                                  
                                  
                                  1,947
                                  
                                  
                                  
                                  2,617
                                  
                                  
                                  
                                  1,323
                                  
                                  
                                  
                                  1,077Net
      income
                                  
                                  $
                                  3,081
                                  
                                  
                                  $
                                  5,665
                                  
                                  
                                  $
                                  5,455
                                  
                                  
                                  $
                                  3,273
                                  
                                  
                                  $
                                  2,955Per
      Share Data:Basic
      net income
                                  
                                  $
                                  0.42
                                  
                                  
                                  $
                                  0.74
                                  
                                  
                                  $
                                  0.68
                                  
                                  
                                  $
                                  0.45
                                  
                                  
                                  $
                                  0.39Diluted
      net income
                                  
                                  
                                  0.42
                                  
                                  
                                  
                                  0.73
                                  
                                  
                                  
                                  0.67
                                  
                                  
                                  
                                  0.45
                                  
                                  
                                  
                                  0.38Cash
      dividends declared
                                  
                                  
                                  0.34
                                  
                                  
                                  
                                  0.32
                                  
                                  
                                  
                                  0.30
                                  
                                  
                                  
                                  0.28
                                  
                                  
                                  
                                  0.26Year-end
      book value
                                  
                                  
                                  11.21
                                  
                                  
                                  
                                  11.05
                                  
                                  
                                  
                                  10.61
                                  
                                  
                                  
                                  10.16
                                  
                                  
                                  
                                  9.74Selected
      Year-End Balance Sheet Data:Total
      assets
                                  
                                  $
                                  817,213
                                  
                                  
                                  $
                                  779,140
                                  
                                  
                                  $
                                  743,370
                                  
                                  
                                  $
                                  701,094
                                  
                                  
                                  $
                                  508,961Loans
      receivable, net of deferred fees
                                  
                                  
                                  626,688
                                  
                                  
                                  
                                  559,956
                                  
                                  
                                  
                                  515,402
                                  
                                  
                                  
                                  473,336
                                  
                                  
                                  
                                  317,156Mortgage-backed
      and related securities
                                  
                                  
                                  80,275
                                  
                                  
                                  
                                  69,893
                                  
                                  
                                  
                                  60,691
                                  
                                  
                                  
                                  70,236
                                  
                                  
                                  
                                  81,169Investment
      securities
                                  
                                  
                                  28,905
                                  
                                  
                                  
                                  46,519
                                  
                                  
                                  
                                  65,326
                                  
                                  
                                  
                                  53,429
                                  
                                  
                                  
                                  52,407Deposits
                                  
                                  
                                  581,488
                                  
                                  
                                  
                                  590,765
                                  
                                  
                                  
                                  562,802
                                  
                                  
                                  
                                  517,544
                                  
                                  
                                  
                                  374,744Borrowings
                                  
                                  
                                  124,365
                                  
                                  
                                  
                                  96,284
                                  
                                  
                                  
                                  85,964
                                  
                                  
                                  
                                  91,342
                                  
                                  
                                  
                                  55,772Stockholders’
      equity
                                  
                                  
                                  104,720
                                  
                                  
                                  
                                  84,033
                                  
                                  
                                  
                                  85,961
                                  
                                  
                                  
                                  84,258
                                  
                                  
                                  
                                  72,394Selected
      Performance Ratios:Return
      on average assets
                                  
                                  
                                  0.39
                                  %
                                  
                                  
                                  0.75
                                  %
                                  
                                  
                                  0.76
                                  %
                                  
                                  
                                  0.60
                                  %
                                  
                                  
                                  0.59
                                  %Return
      on average equity
                                  
                                  
                                  3.62
                                  
                                  
                                  
                                  6.68
                                  
                                  
                                  
                                  6.42
                                  
                                  
                                  
                                  4.40
                                  
                                  
                                  
                                  3.78Avg.
      interest-earning assets to avg. interest-bearing
    liabilities
                                  
                                  
                                  106.89
                                  
                                  
                                  
                                  107.26
                                  
                                  
                                  
                                  106.53
                                  
                                  
                                  
                                  109.40
                                  
                                  
                                  
                                  110.96Noninterest
      expense to average total assets
                                  
                                  
                                  2.40
                                  
                                  
                                  
                                  2.38
                                  
                                  
                                  
                                  2.45
                                  
                                  
                                  
                                  2.64
                                  
                                  
                                  
                                  2.73Interest
      rate spread
                                  
                                  
                                  2.69
                                  
                                  
                                  
                                  2.85
                                  
                                  
                                  
                                  3.10
                                  
                                  
                                  
                                  3.03
                                  
                                  
                                  
                                  2.78Net
      interest margin (2)
                                  
                                  
                                  2.91
                                  
                                  
                                  
                                  3.14
                                  
                                  
                                  
                                  3.33
                                  
                                  
                                  
                                  3.26
                                  
                                  
                                  
                                  2.98Asset
      Quality Ratios:Allowance
      for loan losses to total loans
                                  
                                  
                                  1.28
                                  %
                                  
                                  
                                  1.10
                                  %
                                  
                                  
                                  1.12
                                  %
                                  
                                  
                                  1.08
                                  %
                                  
                                  
                                  0.95
                                  %Net
      charge-offs to average loans
                                  
                                  
                                  0.23
                                  
                                  
                                  
                                  0.17
                                  
                                  
                                  
                                  0.10
                                  
                                  
                                  
                                  0.12
                                  
                                  
                                  
                                  0.09Nonperforming
      loans to total loans
                                  
                                  
                                  0.48
                                  
                                  
                                  
                                  0.32
                                  
                                  
                                  
                                  0.58
                                  
                                  
                                  
                                  0.54
                                  
                                  
                                  
                                  0.30Nonperforming
      assets to total assets
                                  
                                  
                                  0.69
                                  
                                  
                                  
                                  0.30
                                  
                                  
                                  
                                  0.42
                                  
                                  
                                  
                                  0.53
                                  
                                  
                                  
                                  0.34Nonperforming
      assets to total loans
                                  
                                  
                                  0.90
                                  
                                  
                                  
                                  0.42
                                  
                                  
                                  
                                  0.61
                                  
                                  
                                  
                                  0.78
                                  
                                  
                                  
                                  0.55Capital
      Ratios:Average
      equity to average total assets
                                  
                                  
                                  10.66
                                  %
                                  
                                  
                                  11.26
                                  %
                                  
                                  
                                  11.86
                                  %
                                  
                                  
                                  13.69
                                  %
                                  
                                  
                                  15.64
                                  %Equity to assets at year end
                                  
                                  
                                  12.81
                                  
                                  
                                  
                                  10.79
                                  
                                  
                                  
                                  11.56
                                  
                                  
                                  
                                  12.02
                                  
                                  
                                  
                                  14.22Dividend
      payout ratio
                                  
                                  
                                  80.95
                                  
                                  
                                  
                                  43.24
                                  
                                  
                                  
                                  44.12
                                  
                                  
                                  
                                  62.22
                                  
                                  
                                  
                                  66.67








(1)
            Includes
      operations of Trinity Bank, which was acquired on October 31,
      2005.


(2)
            Net
      interest margin is calculated by dividing net interest income, including
      tax equivalent adjustments for tax-exempt investment securities by average
      interest-earning assets for the period.   The tax
      equivalent adjustments were $517, $557, $191, $155, and $0 for 2008, 2007,
      2006,   2005 and 2004,
  respectively.


16


ITEM
      7.
            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations





Overview
of Financial Condition and Results of Operations





Citizens
South Banking Corporation (the “Company”) is a Delaware corporation that owns
all of the outstanding shares of common stock of Citizens South Bank (the
“Bank”), a federally chartered stock savings bank headquartered in Gastonia,
North Carolina.  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
Bank’s principal business activity is offering FDIC-insured deposit accounts 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 residences and in the sale of uninsured
financial products (see Item 1. “Business” of this report for additional
details).





Our
primary business strategy is to operate as a full-service community bank,
offering a complete array of both commercial and retail loan and deposits,
mortgage banking activities, brokerage services, and other related financial
services.  In executing this strategy, the Company has 1) concentrated
much of its lending efforts on local nonresidential real estate loans, business
loans and consumer loans; 2) originated a large portion of all fixed-rate
one-to-four family residential loans as a broker for a third party, and 3)
focused its deposit gathering efforts on local core deposits (demand deposit
accounts, money market accounts, and savings accounts).  Management
expects to continue to focus on executing this business strategy in
2009.





On
December 12, 2008, Citizens South Banking Corporation entered into a Letter
Agreement (the "Purchase Agreement") with the United States Department of the
Treasury ("U.S. Treasury") pursuant to which the Company has issued and sold to
Treasury: (i) 20,500 shares of the Company's Fixed Rate Cumulative Perpetual
Preferred Stock, Series A, par value $0.01 per share (the "Series A Preferred
Stock"), having a liquidation amount per share equal to $1,000, for a total
price of $20,500,000 and (ii) a warrant (“Warrant”) to purchase 428,870 shares
of the Company's common stock, par value $0.01 per share (the "Common Stock"),
at an exercise price per share of $7.17.  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. According the original Purchase Agreement,
the Company may not redeem the Series A Preferred Stock during the first three
years except with the proceeds from a qualified equity
offering.  However, subsequent to the execution of the Purchase
Agreement, legislation was passed which allowed the repayment of the Series A
Preferred Stock to be repaid at any time from non-equity
sources.  After three years, the Company may, at its option, redeem
the Series A Preferred Stock at the liquidation amount plus accrued and unpaid
dividends. 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. 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 will be accounted for as components of Tier 1 capital.  The
Series A Preferred Stock and the Warrant were issued in a private placement
exempt from registration pursuant to Section 4(2) of the Securities Act of 1933,
as amended. The Company has agreed to register for resale the Series A Preferred
Stock, the Warrant and the shares of common stock underlying the Warrant (the
"Warrant Shares") if and when requested to do so in writing by the U.S.
Treasury.  Neither the Series A Preferred Stock nor the Warrant will
be subject to any contractual restrictions on transfer, except that the U.S.
Treasury may only transfer or exercise an aggregate of one-half of the Warrant
Shares prior to the earlier of the date on which 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" and December 31,
2009. The U.S. Treasury also placed certain restrictions on the amount and type
of compensation that can be paid to certain senior level executives of the
Company.


17


The
Bank’s results of operations are significantly affected by general economic and
competitive conditions, changes in interest rates, and actions of regulatory and
governmental authorities. The Bank’s results of operations are also 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.  The provision for loan losses is affected by the Company’s
actual loan losses, amount of delinquent loans, local economic conditions, and
the collateral position of our loan portfolio.  Noninterest income
includes fee income generated from deposit and loan accounts, mortgage banking
fees, commissions earned from the sale of uninsured investment products,
increases in the cash value of bank-owned life insurance policies, net gains
(losses) from the sale of assets and other noninterest income.  The
Bank’s noninterest expense primarily consists of compensation and employee
benefits, occupancy expense, professional services, advertising, amortization of
intangible assets and other noninterest expenses.





Net
income was $3.1 million, or $0.42 per diluted share, for the year ended December
31, 2008, compared to $5.7 million, or $0.73 per diluted share, for the year
ended December 31, 2007.  The earnings resulted in a return on average
equity of 3.62% in 2008, compared to 6.68% in 2007, and a return on average
assets of 0.39% in 2008, compared to 0.75% in 2007.  Management’s
Discussion and Analysis is provided to assist in understanding and evaluating
the results of operations and financial condition of the Company and its
subsidiaries.  The following discussion should be read in conjunction
with the consolidated financial statements and related notes included in Item 8
of this annual report.





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, 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.





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.


18


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





Effective
September 30, 2008, management evaluated the Company’s investment portfolio and
determined that the $468,000 impairment on a $1.0 million trust preferred
collateralized debt obligation was other-than-temporary.  This
investment is collateralized by trust preferred securities that were issued by a
pool of 40 banks operating throughout the country.  Management
determined that the impairment was other-than-temporary because 1) two of the
original 40 banks had defaulted on their payments; 2) the security, which had an
original credit rating of “A-”, was on negative watch and subject to downgrade
by one or more of the credit rating agencies; and 3) the interest rate of LIBOR
plus 105 basis points on this security was well below the current pricing for
bank capital which approximated LIBOR plus 400 basis points at September 30,
2008.  Management determined that it was unlikely that the pricing for
bank capital would return to a level consistent with the pricing on the
Company’s security in the foreseeable future.  In accordance with SFAS
No. 157, “Fair Value
Measurements,” the Company uses valuation techniques that are appropriate
and consistently applied.  A 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.


19


Due to
the lack of liquidity for this type of security in the current environment, the
security was valued using Level 3.  The fair value was prepared by an
independent third party using a discounted cash flow model using various default
assumptions ranging from 10% to 40%.  The fair value of $532,000 was
determined based on a weighted average of the various default assumptions, with
the 20% default rate as the most likely scenario over the life of the
security.  The default rate on this security at the time of the
valuation was 5.25%.





Effective
December 31, 2008, management evaluated the Company’s investment portfolio and
determined that all 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 unrealized losses as “other-than-temporary” as of December 31,
2008.





Comparison
of Financial Condition for the Years Ended December 31, 2008 and
2007





Total
assets increased by $38.1 million, or 4.9%, from $779.1 million at December 31,
2007, to $817.2 million at December 31, 2008.   The majority of
this growth was due to a $66.7 million, or 11.9%, increase in outstanding loans
from $560.0 million at December 31, 2007, to $626.7 million at December 31,
2008.   Most of the Company’s loan growth was in loans secured by
commercial real estate.  During 2008, these loans, which include
construction loans, multifamily residential loans, and nonresidential real
estate loans, increased by $27.6 million, or 7.6%, to $393.1 million at December
31, 2008.  These loans are typically secured by owner-occupied
professional office buildings, retail properties, churches, speculative
residential properties, or residential subdivisions located in the Company’s
primary lending area.  The Company does not actively originate
commercial real estate loans that are secured by hotels, motels, golf courses,
or resort properties. Management plans to continue to emphasize the origination
of owner-occupied residential and commercial real estate loans in the Company’s
primary lending area in the coming year. Also during 2008, the Company’s
portfolio of one-to-four family residential loans increased by $6.2 million, or
7.9%, from $78.6 million to $84.8 million. The Company has not been an
originator or purchaser of option adjustable rate or “no documentation”
portfolio loans and the portfolio does not include any mortgage loans that are
considered “sub-prime.” The Company originates and closes a large portion of all
new one-to-four family residential loans as a broker for independent third
parties on a servicing-released basis.  This generates additional fee
income and reduces the potential adverse effects of rising interest rates on the
Company’s future earnings that normally result from holding long-term fixed-rate
loans.   Management expects that in 2009 the Company’s portfolio
of one-to-four family mortgage loans will continue to increase as a number of
competitors have exited this business sector due to the housing
slowdown.  In addition, mortgage loan interest rates have become more
attractive for borrowers, thus increasing opportunities for customers to
refinance their existing mortgage loans.  During 2008, consumer loans
increased by $31.9 million, or 38.8%, to $114.3 million at December 31,
2008.  Approximately $87.4 million, or 76.5%, of these consumer loans
were home equity loans and lines of credit secured by a second lien on
residential properties.  These loans typically have a loan-to-value
ratio of 90% or less (including any senior liens) and are generally secured by
owner-occupied residential properties located in the Company’s primary lending
area.  Management plans to continue to grow its consumer loan
portfolio in 2009 by continuing an incentive plan for its retail branch
managers.  However, due to declining housing prices, management has
lowered the loan-to-value ratio on new home equity lines of credit to
85%.  Commercial business loans increased by $868,000, or 2.6%, to
$34.5 million.  Management expects similar growth of its commercial
business loans in 2009.





In order to facilitate continued loan
growth during 2009, the Company plans to open a loan production office in
Charlotte, North Carolina during the first quarter of 2009.  This
office is expected to be staffed by one commercial lender and one residential
mortgage lender.  However, the Company’s ability to grow the existing
loan portfolio is largely dependent on the economy of the Charlotte metropolitan
area.  The local economy slowed during the second half of 2008,
resulting in slower loan growth during that period.  A continued
slowdown in the local economy is expected for 2009 which will likely result in a
slower loan growth rate in 2009 as compared to 2008.  Management will
continue to focus on maintaining the current credit quality of the
portfolio.





Cash and
cash equivalents decreased by $19.6 million, or 65.9%, from $29.7 million at
December 31, 2007, to $10.1 million at December 31, 2008. This decrease was
primarily due to the $66.7 million increase in loans outstanding, a $10.4
million increase in mortgage-backed securities, a $9.3 million decrease in
deposits, stock repurchases of $1.0 million and $2.5 million in cash dividends
paid during 2008.  These decreases in cash and cash equivalents were
partly offset by a $17.6 million decrease in investment securities and a $28.1
million increase in borrowed money.  Management expects that cash and
cash equivalents will remain fairly stable in 2009 as new loans are funded from
maturing investment and mortgage-backed securities, deposit growth and increased
borrowed money as needed.


20


Investment
securities decreased by $17.6 million, or 37.9%, from $46.5 million at December
31, 2007, to $28.9 million at December 31, 2008.  This decrease was
primarily the result of the sale of $19.2 million in investment securities and
$2.5 million in normal maturities and calls.  The funds generated from
the sale of investment securities were primarily used to fund new loan
growth.  This decrease in investment securities was partly offset by
the purchase of $5.8 million in investment securities in
2008.   Mortgage-backed securities increased by $10.4 million, or
14.9%, from $69.9 million at the end of 2007, to $80.3 million at the end of
2008.  This increase was primarily due to the purchase of $35.0
million of mortgage-backed securities, which was partly offset by the maturity
and principal amortization of $14.2 million of mortgage-backed securities and
the sale of $12.4 million of mortgage-backed securities during the year.
Management expects that in 2009 the balances of its investment and
mortgage-backed securities portfolios will increase as management leverages the
capital raised from the sale of preferred stock in order to generate increased
earnings.





Premises
and equipment decreased by $1.1 million, or 6.3%, to $16.8 million at December
31, 2008.  Normal depreciation during 2008 amounted to $1.1 million
which was the primary reason for the decrease. In 2008 the Company opened a
full-service office in Rock Hill, South Carolina in a leased
building.  The Company also closed one loan production office and
consolidated two other loan production offices into existing full-service branch
offices.  All three of these offices were located in leased office
space.  In 2009, the Company plans to open a loan production office in
a leased office building in Charlotte, North Carolina.  This office
will be used to originate primarily commercial and residential
loans.  The Company will continue to evaluate potential branch sites
in its existing market area as opportunities arise.





Total
liabilities increased by $17.4 million, or 2.5%, from $695.1 million at December
31, 2007, to $712.5 million at December 31, 2008.   This increase
was primarily due to a $28.1 million, or 29.2%, increase in borrowed money from
$96.3 million at December 31, 2007, to $124.4 million at December 31,
2008.  Borrowed money includes advances from the Federal Home Loan
Bank, repurchase agreements, subordinated debt and retail repurchase
agreements.  Funds generated from the increase in borrowed money were
primarily used to fund new loans, purchase mortgage-backed securities, and
offset decreases in deposits.  Management will use borrowed money as
an additional source of liquidity as needed.  In addition, from time
to time, management may use borrowed money to engage in various leverage
strategies to increase income as opportunities arise.





While the
Company’s total deposits decreased from $590.8 million at December 31, 2007, to
$581.5 million at December 31, 2008, demand deposit accounts, or checking
accounts, increased by $20.7 million, or 20.4%, to $122.7 million at December
31, 2008.  Management is committed to increasing demand deposit
accounts and building new and enhancing existing customer relationships through
improving technology, expanding its branch network and focused marketing
efforts. In 2008 the Company focused on two new products for both its commercial
and retail customers that significantly contributed to the strong growth in
demand deposit accounts in 2008.  The first product is our remote
deposit capture, which gives our commercial customers the ability to make
deposits of checks remotely without physically visiting a branch
office.  This allows our commercial sales force the opportunity to
solicit business from commercial customers that may not be located near an
existing branch office.  The second product is a high-yield checking
account product that compares favorably with some of our competitors who offer a
higher interest rate on their checking account, but include numerous conditions
in order to receive the higher rate.  In addition, we offer all-day
banking, which eliminated the 2:00 p.m. cutoff for current day processing of
deposits.  In 2009 we plan to continue to market these and other core
products in our local area through media outlets and through incentive plans
paid to employees for new core customer accounts.  During 2008, money
market deposit accounts decreased by $26.4 million, or 20.4%, to $103.3 million
at December 31, 2008, savings accounts decreased by $1.3 million, or 11.01%, to
$10.7 million at December 31, 2008, and time deposits decreased $2.3 million, or
0.7%, to $344.8 million at December 31, 2008.  These decreases were
primarily due to the significant decrease in short-term interest rates in 2008,
which made alternative investments more attractive to customers.  In
addition, during 2008 several local competitors offered above-market interest
rates on local deposits which were more attractive than the deposit rates
offered by the Company.  Since borrowed money was a less costly source
of liquidity for the Company, we did not actively participate in offering above
market interest rates on deposits.  By the end of 2008, deposit
pricing from local competitors had normalized.  Management is focused
on growing its deposit base from within the Company’s market
area.  However, from time to time brokered time deposits may be used
as an additional source of liquidity as needed.  As of December 31,
2008, approximately $6.4 million, or 1.1% of total deposits, were brokered time
deposits.


21


Total
stockholders’ equity increased by $20.7 million, or 24.6%, from $84.0 million at
December 31, 2007 to $104.7 million at December 31, 2008.  This
increase was primarily due to the sale of $20.5 million in Series A Preferred
stock, net income of $3.1 million and a $368,000 decrease in accumulated losses
on investments available for sale.  These increases in stockholders’
equity were partly offset by the repurchase of 102,828 shares of common stock
for $1.0 million at an average price of $9.91 per share. These shares were
repurchased as a part of stock repurchase plans announced in November 2007 and
June 2008.  The November 2007 repurchase plan provided for the
repurchase of 200,000 shares, or approximately 2.5% of the then outstanding
shares.  All of the shares authorized under this plan were repurchased
by June 2008 at an average price of $10.77.  The June 2008 repurchase
plan provided for the repurchase of 200,000 shares, or approximately 2.7% of the
then outstanding shares.  As of December 31, 2008, the Company had
repurchased 9,476 shares under the plan.  The decrease in total
stockholders’ equity during 2008 was also partly offset by the payment of $2.5
million in cash dividends, or $0.34 per share, and the recording of a $350,000
post-retirement liability on split dollar life insurance
arrangements.





Results
of Operations





The
following discussion relates to operations for the year ended December 31, 2008
compared to the year ended December 31, 2007, as well as the year ended December
31, 2007 compared to the year ended December 31, 2006.





Comparison
of Results of Operations for the Years Ended December 31, 2008 and
2007





Overview.The
Company reported net income of $3.1 million, or $0.42 per diluted share, for the
year ended December 31, 2008, compared to $5.7 million, or $0.73 per diluted
share, for the year ended December 31, 2007.  The earnings resulted in
a return on average equity of 3.62% in 2008, compared to 6.68% in 2007, and a
return on average assets of 0.39% in 2008, compared to 0.75% in
2007.





Net interest
income.The Company’s net interest income was flat at $20.2
million for the year ended December 31, 2008, as compared to the year ended
December 31, 2007.  During 2008 the Company experienced a 23 basis
point decrease in the net interest margin from 3.14% for 2007 to 2.91% for 2008.
The compression of the net interest margin was caused in part by a series of
decreases in the federal funds rate by the Federal Reserve Board during 2008
that resulted in a 400 basis point decrease in the prime lending rate during the
year from 7.25% at the end of 2007 to 3.25% at the end of 2008.  At
December 31, 2008, the Company had approximately $270 million in loans, or 43%
of the Company’s loan portfolio, repricing each month, the majority of which
were tied to the prime lending rate. This sharp decrease in short-term interest
rates did not provide sufficient time for many of the Company’s time deposits to
reprice at a lower interest rate.  As a result, the yield on assets
for 2008 decreased at a faster rate than the decrease in the cost of funds,
causing the spread between interest-earning assets and interest-bearing
liabilities to decrease from 2.85% to 2.69%.  When short-term interest
rates stabilize, the Company’s net interest margin should begin to expand as its
portfolio of time deposits reprices at lower market rates without commensurate
offsetting decreases in the yield on its prime-based loan
portfolio.  The negative effects of the net interest margin
compression were largely offset by strong balance sheet growth during the year.
During 2008, the Company’s average interest-earning assets increase from $663.0
million in 2007 to $711.7 million in 2008.





Interest
income for the year ended December 31, 2008, decreased by $4.1 million, or 8.8%,
to $42.6 million. This decrease was largely due to the fact that the average
yield on interest-earning assets decreased by 107 basis points from 7.13% for
2007 compared to 6.06% for 2008.  The decrease in average asset yields
was primarily due to a 400 basis point decrease in the prime lending rate during
2008.  The negative effects of the decreased average yield on
interest-earning assets were partly offset by a $48.7 million, or 7.3%, increase
in average interest-earning assets from $663.0 million in 2007 to $711.7 million
in 2008.  Average outstanding loans increased by $66.5 million, or
12.6%, from $526.9 million to $593.4 million, while the average yield on loans
decreased from 7.73% in 2007 to 6.29% for 2008. These changes were primarily the
result of organic loan growth during the year, and lower market interest rates
during 2008.  As a result, interest income on loans decreased by $3.4
million, or 8.5%, to $37.2 million in 2008.


22


Interest
earned on interest-bearing bank balances decreased by $290,000, or 64.9%, to
$157,000 in 2008.  The average balance of interest-bearing bank
balances decreased by $2.6 million, or 27.7%, to $6.8 million and the average
yield on these deposits decreased by 244 basis points to
2.29%.  Interest earned on investment securities decreased by $1.3
million, or 42.4%, to $1.4 million in 2008.  Tax equivalent
adjustments using a 34% tax rate were made to interest income on investment
securities in the amounts of $516,000 and $557,000 for 2008 and 2007,
respectively.  This decrease in interest income on investment
securities was also due to a $28.8 million, or 46.4%, decrease in the average
outstanding balance of investment securities to $33.3 million in
2008.  The average tax-equivalent yield on investment securities
increased by 38 basis points to 5.48% for 2008 due to an increased level of
higher-yielding municipal securities during 2008.   Interest
income from mortgage-backed securities increased by $863,000, or 29.4%, to $3.8
million in 2008.  This increase was largely due to a 31 basis point
increase in the average yield from 4.55% in 2007 to 4.86% in 2008.  In
addition, the average balance of mortgage-backed securities increased by $13.6
million, or 21.0% to $78.2 million for 2008.  The increase in the
average yield on mortgage-backed securities was due in part to the purchase of
higher-yielding longer-term government agency mortgage-backed securities during
2008.  Management expects the levels of investment and mortgage-backed
securities will increase during 2009, as the Company leverages excess capital to
increase future earnings.





Interest
expense decreased $4.1 million, or 15.5%, to $22.4 million for the year ended
December 31, 2008. This decrease was largely due to a 92 basis point decrease in
the average cost of funds from 4.29% in 2007 to 3.37% in 2008.  Partly
offsetting this decrease in the average cost of funds was a $47.7 million, or
7.7%, increase in average interest-bearing liabilities from $618.1 million in
2007 to $665.8 million in 2008. Interest expense on deposits decreased $5.1
million, or 22.8%, to $17.2 million in 2008.  This decrease was
primarily due to a 97 basis point decrease in the average cost of deposits due
to falling interest rates during 2008.  The positive impact of a
decrease in the cost of deposits was partly offset by a $3.8 million, or 0.7%,
increase in average deposits in 2008. Average deposits increased due to organic
growth generated from the Company’s primary market area.  Interest
paid on borrowed money increased by $988,000, or 23.6%, to $5.2 million in
2008.  Average borrowings increased by $43.9 million, or 53.1%, to
$126.6 million for 2008, while the average rate paid on borrowings decreased
from 5.06% in 2007 to 4.09% in 2008.  Average borrowings increased in
order to fund loan growth, purchase mortgage-backed securities, and fund
decreases in deposits.  The Company may increase the level of
borrowings to provide liquidity for operating purposes, to purchase investment
securities, fund loan growth, and fund any deposit decreases.  If
these borrowing levels increase, there will be a corresponding increase in
interest expense.





Provision for Loan
Losses.The Company provided $3.3 million and $1.3 million in
loan loss provisions for the years ended December 31, 2008 and 2007,
respectively.  The allowance for loan losses as a percentage of total
loans was 1.28% at December 31, 2008, and 1.10% at December 31, 2007. The
provision for loan losses increased due to strong organic growth in the
Company’s loan portfolio of $66.7 million, coupled with net charge-offs of $1.4
million during the year.





In 2008, the Charlotte
metropolitan area experienced moderate decreases in housing prices, an increased
unemployment rate, decreased housing starts and housing sales and decreased
commercial activity.  However, the economic slowdown in the Charlotte
metropolitan area has generally been less severe than the economic slowdown
experienced in other large metropolitan areas of the country.  Due to
the slowdown in the local economy,the level of nonperforming loans
increased by $1.2 million, to $3.0 million at December 31, 2008.  As a
result, the ratio of nonperforming loans to gross loans increased from 0.32% at
December 31, 2007, to 0.48% at December 31, 2008.  Also, other real
estate owned increased by $2.1 million to $2.6 million at December 31,
2008.  The Company has not been an originator or purchaser of option
adjustable rate or “no documentation” portfolio loans and the Company’s loan
portfolio does not include any mortgage loans that are considered
“sub-prime.”  Therefore, none of the foreclosures were the result of
any “sub-prime” activity by the Company.  The properties acquired
through foreclosure consisted of 12 one-to-four family residential properties,
two residential lots and one commercial building located in the Company’s
primary lending area. These properties are in various stages of
disposition.  Nonperforming assets increased by $3.3 million to $5.6
million at December 31, 2008, resulting in an increase in the ratio of
nonperforming assets to total assets from 0.30% at December 31, 2007, to 0.69%
at December 31, 2008.  Refer to “Allowance for Loan Losses” for
further discussion.


23


Noninterest
Income.For the year ended December 31, 2008, noninterest
income decreased by $543,000, or 8.3%, from $6.6 million in 2007 to $6.0 million
in 2008.  During this period of time, the Company experienced a
$161,000 decrease in fee income from mortgage banking activities and a $100,000
decrease in fee income on lending activities.  The decrease in
mortgage banking income was largely due to reduced mortgage loan originations
during 2008 as a result of the slowdown in the local housing
market.  As a result of the slowdown in the local mortgage market,
many local competitors have exited the market.  This reduced
competition, coupled with a decrease in long-term mortgage lending rates, could
result in stable mortgage banking activity for the coming year.  The
decrease in fee income from lending activities was primarily due to a slowdown
in originations of speculative residential lending and acquisition and
development lending activity.  Both of these types of loans generally
generate attractive fee income.  Given the current state of the local
housing market, management does not expect to originate a significant amount of
these types of loans in 2009, resulting in a continued decrease in fee income
from lending activity for 2009.  Dividend income on FHLB stock
decreased by $32,000 from 2007 to 2008.  This decrease was primary the
result of lower dividend payments resulting from the significant decrease in
interest rates during 2008.  Management expects this trend to continue
in 2009, as the FHLB continues to lower its dividend payments to
stockholders.  In 2007, the Company also recognized $112,000 in net
life insurance proceeds as a result of the untimely death of one of the
Company’s officers after a courageous fight with cancer.   The
Company did not recognize any life insurance benefits in 2008.  The
Company also recognized a $250,000 decrease from the fair value adjustment on
deferred compensation assets.  This decrease in the fair value
adjustment on deferred compensation assets is offset by a corresponding decrease
in compensation expense, resulting in no net impact on net
income.  These decreases in noninterest income were partly offset by a
$309,000 increase in fee income on deposit accounts.  This increase
was primarily due to the increased fee income resulting from a $20.7 million
increase in the Company’s demand deposit accounts.





Net gain
on sale of assets decreased by $159,000 to $164,000 in 2008.  During
the year ended December 31, 2008, the Company sold $2.5 million in investment
securities and $14.2 million in mortgage-backed securities at a combined net
gain of $284,000, $537,000 of real estate acquired through foreclosure at a net
loss of $69,000, and $330,000 of fixed assets at a net loss of
$51,000.  During the year ended December 31, 2007, the Company sold
$8.7 million in investment securities and $8.3 million in mortgage-backed
securities at a combined net loss of $74,000, $334,000 of real estate acquired
through foreclosure at a net loss of $17,000, $202,000 of loans at a net gain of
$5,000, and $801,000 of fixed assets at a net gain $409,000.





Noninterest
Expense.The Company’s noninterest expense increased by $1.3
million, or 7.4%, from $17.9 million in 2007 to $19.2 million in
2008.  This increase was largely due to a $486,000, or 5.1%, increase
in compensation expense from $9.6 million in 2007 to $10.1 million in
2008.   Additional staffing related to the opening of a new
full-service branch office in the first quarter of 2008 was the primary reason
for the increased compensation.  Occupancy expense increased by
$11,000, or 0.4%, to $2.7 million in 2008.  During 2008, the Company
closed one mortgage loan origination office and consolidated two other mortgage
loan origination offices into existing branch offices.  All of the
loan production offices were located in leased space.  Also during
2008, the Company opened a full-service office in Rock Hill, South Carolina in a
leased building.  In 2009, the Company plans to open a loan
origination office in leased space in Charlotte, North
Carolina.  Professional fees increased by $323,000, or 59.4%, to
$867,000.  This increase was due to higher audit and legal costs
associated with complying with increased regulatory and accounting issues facing
our industry.  Also, the former Chief Executive Officer of Trinity
Bank, which was acquired in 2005, retired and was placed on a consulting
contract which was negotiated as a condition of the sale of Trinity
Bank.  The Company also recognized a $250,000 decrease from the fair
value adjustment on deferred compensation assets.  This decrease in
the fair value adjustment on deferred compensation assets is offset by a
corresponding decrease in compensation expense, resulting in no net impact on
net income.  Other expenses increased by $351,000, or 8.4%, to $4.5
million.  This increase was primarily due to higher expenses for loan
collection, management and disposition costs related to real estate acquired
through foreclosure, processing a larger number of demand deposit accounts, and
miscellaneous costs related to operating an additional full-service office which
was opened in the first quarter of 2008.  Also there were
restructuring costs of $220,000 in 2008 related to severance and other costs
related to a realignment of the Company’s management
structure.   The $117,000 decrease in the amortization of
intangible assets was due to the normal decrease associated with amortizing the
core deposit intangible on an accelerated basis.  Estimated
amortization expense in 2009 is expected to be $314,000, compared to $512,000 in
2008.  Also, in 2008, there were no merger-related expenses as
compared to $57,000 in 2007.  The expenses incurred in 2007 were
attributable to the acquisition of Trinity Bank in October
2005.


24


In 2009,
the FDIC proposed amendments to the restoration plan for the Deposit Insurance
Fund.  This amendment proposes the imposition of a 10 basis point
emergency special assessment on insured depository institutions as of June 30,
2009.  The assessment is proposed to be collected on September 30,
2009.  The interim rule would also permit the FDIC to impose an
emergency special assessment after June 30, 2009, of up to 20 basis points if
necessary to maintain public confidence in federal deposit insurance. Based on
insured deposits for the fourth quarter of 2008, this special assessment, if
implemented as proposed, would equal approximately $1.2
million.  This special assessment if implemented as proposed will have
a significant impact on the results of operations of the Company for
2009.





Expenses
related to the impairment of securities increased by $306,000 from $162,000 in
2007 to $468,000 in 2008.  In 2008, management evaluated the Company’s
investment portfolio and determined that the $468,000 impairment on a $1.0
million trust preferred collateralized debt obligation was
other-than-temporary.





Income Taxes.The
Company’s provision for income taxes was $639,000 and $1.9 million for the years
ended December 31, 2008 and 2007, respectively.  The change in the tax
provision was primarily due to a $3.9 million decrease in pretax
income.  The effective tax rate decreased from 25.6% to 17.2% due to a
larger percentage of income being derived from tax-advantaged assets such as
municipal securities, U.S. Government Agency securities, and bank-owned life
insurance that generate tax-exempt income.   Management expects
to decrease its level of income generated from tax-advantaged sources in 2009,
resulting in an increase in the effective tax rate for 2009.





Comparison
of Results of Operations for the Years Ended December 31, 2007 and
2006





Overview.The
Company reported net income of $5.7 million, or $0.73 per diluted share, for the
year ended December 31, 2007, compared to $5.5 million, or $0.67 per diluted
share, for the year ended December 31, 2006.  The earnings resulted in
a return on average equity of 6.68% in 2007, compared to 6.42% in 2006, and a
return on average assets of 0.75% in 2007, compared to 0.76% in
2006.





Net Interest
Income.The Company’s net interest income decreased by
$405,000, or 2.0%, to $20.2 million for the year ended December 31, 2007,
compared to $20.6 million for the year ended December 31, 2006.  This
decrease was largely due to a 19 basis point decrease in the net interest margin
from 3.33% for 2006 to 3.14% for 2007. The compression of the net interest
margin was caused in part by a series of three decreases in the federal funds
rate by the Federal Reserve Board during the second half of 2007 that resulted
in a 100 basis point decrease in the prime lending rate during the year to 7.25%
at the end of 2007.  At December 31, 2007, the Company had
approximately $251 million in loans, or 45% of the Company’s loan portfolio,
repricing each month, the majority of which were tied to the prime lending rate.
While market interest rates were generally higher in 2007 than in 2006, this
sharp decrease in short-term interest rates over a short period of time (less
than four months) at the end of 2007 did not provide sufficient time for many of
the Company’s time deposits to reprice at a lower interest rate.  As a
result, the yield on assets for 2007 did not grow as fast as the increase in the
cost of funds, causing the spread between interest-earning assets and
interest-bearing liabilities to decrease from 3.10% to 2.85%.  When
short-term interest rates stabilize, the Company’s net interest margin should
begin to expand as its portfolio of time deposits reprices at lower market rates
without any offsetting decreases in the yield on its prime-based loan
portfolio.  During 2007, the Company’s ratio of average
interest-earning assets to average interest-bearing liabilities increased from
106.5% in 2006 to 107.3% in 2007.  This increasing ratio of average
interest-earning assets to average interest-bearing liabilities partly offset
the negative effect of the decreased net interest margin.





Interest
income for the year ended December 31, 2007, increased by $3.8 million, or 8.9%,
to $46.7 million. This increase was largely due to the fact that average
interest-earning assets increased by $37.9 million, or 6.1%, from $625.1 million
in 2006 to $663.0 million in 2007.  In addition, while short-term
interest rates fell during the last four months of 2007, the increases in the
prime-lending rate during 2006, which were unchanged for the first three
quarters of 2007, resulted in a 23 basis point increase in the yield on
interest-earnings assets to 7.13% for 2007.  Average outstanding loans
increased by $33.6 million, or 6.8%, from $493.3 million to $526.9 million,
while the average yield on loans increased from 7.59% to 7.73% from 2006 to
2007. These changes were primarily the result of organic loan growth during the
year, and higher market interest rates during the first three quarters of
2007.  As a result, interest income on loans increased by $3.2
million, or 8.6%, to $40.7 million in 2007.


25


Interest
earned on interest-bearing bank balances decreased by $392,000, or 46.8%, to
$447,000 in 2007.  The average balance of interest-bearing bank
balances decreased by $7.3 million, or 43.6%, to $9.4 million and the average
yield on these deposits decreased by 25 basis points to
4.73%.  Interest earned on investment securities increased by $1.0
million, or 47.5%, to $3.2 million in 2007.  Tax equivalent
adjustments using a 34% tax rate were made to interest income on investment
securities in the amounts of $557,000 and $191,000 for 2007 and 2006,
respectively.  This increase in interest income was primarily due to
an $11.5 million, or 22.8%, increase in the average outstanding balance of
investment securities to $62.0 million in 2007.  The average
tax-equivalent yield on investment securities increased by 87 basis points to
5.10% for 2007 due to the increased level of short-term interest rates during
the first three quarters of 2007 and an increased level of higher-yielding
municipal securities during 2007.   Interest income from
mortgage-backed securities increased by $304,000, or 11.5%, to $2.9 million in
2007.  This increase was largely due to a 47 basis point increase in
the average yield from 4.08% in 2006 to 4.55% in 2007.  The average
balance of mortgage-backed securities increased by 0.7% to $64.6 million for
2007.  The increase in the average yield on mortgage-backed securities
was due in part to slower prepayment levels resulting from higher mortgage
interest rates during the year.





Interest
expense increased $4.2 million, or 18.9%, to $26.5 million for the year ended
December 31, 2007. This increase was largely due to average interest-bearing
liabilities increasing by $31.3 million, or 5.3%, from $586.8 million in 2006 to
$618.1 million in 2007.  In addition, the average cost of funds
increased by 49 basis points to 4.29% in 2007.  Interest expense on
deposits increased $4.2 million, or 23.3%, to $22.3 million in
2007.  This increase was primarily due to a $34.8 million, or 7.0%,
increase in average deposits in 2007 and a 55 basis point increase in the cost
of deposits to 4.17% in 2007.  Average deposits increased due to
organic growth generated from the Company’s normal market area.  The
cost of funds increased due to the increase in short-term rates during 2006
which remained in effect for the first three quarters of
2007.  Interest paid on borrowed money increased by $9,000, or 0.2%,
to $4.2 million in 2007.  Average borrowings decreased by $3.5
million, or 4.0%, to $82.7 million for 2007, while the average rate paid on
borrowings increased from 4.85% in 2006 to 5.06% in 2007 due to the maturities
of lower costing borrowings during the year.





Provision for Loan
Losses.The Company provided $1.3 million and $1.2 million in
loan loss provisions for the years ended December 31, 2007 and 2006,
respectively.  The allowance for loan losses as a percentage of total
loans was 1.10% at December 31, 2007, and 1.12% at December 31, 2006. The
provision for loan losses increased due to strong organic growth in the
Company’s loan portfolio of $44.6 million, coupled with net charge-offs of
$910,000 during the year. The level of nonperforming loans decreased by $1.2
million, to $1.8 million at December 31, 2007.  As a result, the
Company generated lower late fees generated from delinquent loans and the ratio
of nonperforming loans to net loans decreased from 0.58% at December 31, 2006,
to 0.32% at December 31, 2007.  Also, real estate owned increased by
$390,000 to $529,000 at December 31, 2007.  The Company has not been
an originator or purchaser of option adjustable rate or “no documentation”
portfolio loans and the Company’s loan portfolio does not include any mortgage
loans that are considered “sub-prime.”  Therefore, none of the
foreclosures were the result of any “sub-prime” activity by the
Company.  The properties acquired through foreclosure consist of 13
one-to-four family residential properties located in the Company’s normal
lending area. These properties are in various stages of
disposition.  Nonperforming assets decreased by $809,000 to $2.3
million at December 31, 2007, resulting in decrease in the ratio of
nonperforming assets to total assets from 0.42% at December 31, 2006, to 0.30%
at December 31, 2007.  Refer to “Allowance for Loan Losses” within
Item 7 for further discussion.





Noninterest
Income.For the year ended December 31, 2007, noninterest
income increased by $422,000, or 6.9%, from $6.1 million to $6.6
million.  The Company experienced an increase of $352,000 from
mortgage banking activities.  This was largely due to strong
mortgage-banking activity during most of 2007.  Mortgage banking
activity slowed toward the end of 2007; however, management expects that
long-term mortgage lending rates will be more attractive in 2007, resulting in
steady mortgage lending activity for 2007.  The Company also
recognized $112,000 in net life insurance proceeds as a result of the untimely
death of one of the Company’s officers after a courageous fight with
cancer.   These increases in noninterest income were partly
offset by decreases of $133,000 in fee income received on deposit accounts,
$161,000 in lower fee income received from lending activities, and $85,000 from
the fair value adjustment on deferred compensation assets. The decrease in fee
income on deposit accounts was largely due to the trend of lower fees generated
from overdrawn checking accounts.  Management believes that this
negative trend is industry-wide.  However, the negative trend has
slowed recently and a continued focus on growing retail and commercial checking
accounts should result in a moderate improvement in fee income on deposit
accounts in 2007.  Loan fee income decreased primarily as a result of
fewer fees generated on commercial real estate and construction loans, as well
as lower late fees generated from delinquent loans.  The trend in 2007
will largely depend on the Company’s ability to increase loan activity in a
slowing economy.  The decrease in the fair value adjustment on
deferred compensation assets is offset by a corresponding decrease in
compensation expense, resulting in no net impact on net income.


26


Net gain
on sale of assets increased by $254,000 to $323,000 in 2007.  During
the year ended December 31, 2007, the Company sold $8.7 million in investment
securities and $8.3 million in mortgage-backed securities at a combined net loss
of $74,000, $334,000 of real estate acquired through foreclosure at a net loss
of $17,000, $202,000 of loans at a net gain of $5,000, and $801,000 of fixed
assets at a net gain $409,000.  During the year ended December 31,
2006, the Company sold $98,000 in investment securities and $2.2 million in
mortgage-backed securities at a combined net loss of $41,000.  In
addition, during 2006 the Company sold $648,000 in premises and equipment, and
$914,000 in real estate acquired through foreclosure at a net gain of
$111,000.





Noninterest
Expense.The Company’s noninterest expense increased by
$352,000, or 2.0%, from $17.5 million in 2006 to $17.9 million in
2007.  This increase was largely due to a $335,000, or 3.6%, increase
in compensation expense from $9.4 million in 2006 to $9.7 million in
2007.   Staffing increased in 2007 due to the opening of a new
full-service branch office in the first quarter of 2007.  Occupancy
expense increased by $34,000, or 1.3%, to $2.6 million in 2007.  The
Company opened one mortgage loan origination office in leased space during
2007.  The decrease in the amortization of intangible assets was due
to the normal decrease associated with amortizing the core deposit intangible on
an accelerated basis.  Also, in 2007, there were no merger-related
expenses as compared to $57,000 in 2006.  The merger-related expenses
incurred in 2006 were attributable to the acquisition of Trinity Bank in October
of 2005.





Income Taxes.The
Company’s provision for income taxes was $1.9 million and $2.6 million for the
years ended December 31, 2007 and 2006, respectively.  The change was
primarily due to a $460,000 decrease in pretax income.  The effective
tax rate decreased from 32.4% to 25.6% due to a larger percentage of income
being derived from tax-advantaged assets such as municipal securities, U.S.
Government Agency securities, and bank-owned life insurance that generate
tax-exempt income.


27


Net
Interest Income
 
 The net
income of the Company is heavily dependent upon net interest
income.  Net interest income represents the difference between income
on interest-earning assets and expense on interest-bearing
liabilities.  Net interest income also depends on the relative amounts
of interest-earning assets and interest-bearing liabilities and the interest
rate earned or paid on them, respectively.  The following table sets
forth certain information relating to the Company for the years ended December
31, 2008, 2007 and 2006.  For the years indicated, the total dollar
amount of interest income from average interest-earning assets and the resultant
yields, as well as the interest expense on average interest-bearing liabilities,
is expressed both in dollars and rates.
 
 Average
Balances and Net Interest Income Analysis
 
 December 31,
      2008
                                          
                                          
                                          December 31,
      2007
                                          
                                          
                                          December 31,
      2006Interest
                                          
                                          
                                          Average
                                          
                                          
                                          
                                          
                                          
                                          Interest
                                          
                                          
                                          Average
                                          
                                          
                                          
                                          
                                          
                                          Interest
                                          
                                          
                                          AverageAverage
                                          
                                          
                                          Income/
                                          
                                          
                                          Yield/
                                          
                                          
                                          Average
                                          
                                          
                                          Income/
                                          
                                          
                                          Yield/
                                          
                                          
                                          Average
                                          
                                          
                                          Income/
                                          
                                          
                                          Yield/Balance
                                          
                                          
                                          Expense
                                          
                                          
                                          Cost
                                          
                                          
                                          Balance
                                          
                                          
                                          Expense
                                          
                                          
                                          Cost
                                          
                                          
                                          Balance
                                          
                                          
                                          Expense
                                          
                                          
                                          Cost(Dollars
      in Thousands)Assets:Interest-earning
      assets: (1)Loans receivable (2)
                                          
                                          $
                                          593,404
                                          
                                          
                                          $
                                          37,341
                                          
                                          
                                          
                                          6.29
                                          %
                                          
                                          $
                                          526,913
                                          
                                          
                                          $
                                          40,679
                                          
                                          
                                          
                                          7.73
                                          %
                                          
                                          $
                                          493,324
                                          
                                          
                                          $
                                          37,448
                                          
                                          
                                          
                                          7.59
                                          %Interest-bearing
      bank deposits
                                          
                                          
                                          6,819
                                          
                                          
                                          
                                          156
                                          
                                          
                                          
                                          2.29
                                          
                                          
                                          
                                          9,426
                                          
                                          
                                          
                                          446
                                          
                                          
                                          
                                          4.73
                                          
                                          
                                          
                                          16,715
                                          
                                          
                                          
                                          838
                                          
                                          
                                          
                                          5.01Investment
      securities
                                          
                                          
                                          33,285
                                          
                                          
                                          
                                          1,824
                                          
                                          
                                          
                                          5.48
                                          
                                          
                                          
                                          62,044
                                          
                                          
                                          
                                          3,227
                                          
                                          
                                          
                                          5.10
                                          
                                          
                                          
                                          50,537
                                          
                                          
                                          
                                          2,188
                                          
                                          
                                          
                                          4.33Mortgage-backed
      securities
                                          
                                          
                                          78,188
                                          
                                          
                                          
                                          3,803
                                          
                                          
                                          
                                          4.86
                                          
                                          
                                          
                                          64,595
                                          
                                          
                                          
                                          2,940
                                          
                                          
                                          
                                          4.55
                                          
                                          
                                          
                                          64,549
                                          
                                          
                                          
                                          2,636
                                          
                                          
                                          
                                          4.08Total interest-earning
      assets (1)
                                          
                                          
                                          711,696
                                          
                                          
                                          
                                          43,124
                                          
                                          
                                          
                                          6.06
                                          
                                          
                                          
                                          662,978
                                          
                                          
                                          
                                          47,292
                                          
                                          
                                          
                                          7.13
                                          
                                          
                                          
                                          625,125
                                          
                                          
                                          
                                          43,110
                                          
                                          
                                          
                                          6.90Noninterest-earning
      assets
                                          
                                          
                                          88,173
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          90,107
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          91,809Total
      assets
                                          
                                          $
                                          799,869
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          753,085
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          716,934Liabilities
      and Stockholders’ Equity:Interest-bearing
      liabilities:Demand
      deposit accounts
                                          
                                          $
                                          67,562
                                          
                                          
                                          $
                                          1,019
                                          
                                          
                                          
                                          1.51
                                          %
                                          
                                          $
                                          52,810
                                          
                                          
                                          $
                                          917
                                          
                                          
                                          
                                          1.74
                                          %
                                          
                                          $
                                          51,495
                                          
                                          
                                          $
                                          662
                                          
                                          
                                          
                                          1.29
                                          %Money
      market deposit accounts
                                          
                                          
                                          115,639
                                          
                                          
                                          
                                          2,652
                                          
                                          
                                          
                                          2.29
                                          
                                          
                                          
                                          126,247
                                          
                                          
                                          
                                          4,909
                                          
                                          
                                          
                                          3.89
                                          
                                          
                                          
                                          109,553
                                          
                                          
                                          
                                          4,187
                                          
                                          
                                          
                                          3.82Savings
      accounts
                                          
                                          
                                          11,664
                                          
                                          
                                          
                                          42
                                          
                                          
                                          
                                          0.36
                                          
                                          
                                          
                                          14,093
                                          
                                          
                                          
                                          82
                                          
                                          
                                          
                                          0.58
                                          
                                          
                                          
                                          19,569
                                          
                                          
                                          
                                          150
                                          
                                          
                                          
                                          0.77Certificates
      of deposit
                                          
                                          
                                          344,339
                                          
                                          
                                          
                                          13,520
                                          
                                          
                                          
                                          3.93
                                          
                                          
                                          
                                          342,259
                                          
                                          
                                          
                                          16,407
                                          
                                          
                                          
                                          4.79
                                          
                                          
                                          
                                          320,008
                                          
                                          
                                          
                                          13,104
                                          
                                          
                                          
                                          4.09Borrowed
      funds
                                          
                                          
                                          126,624
                                          
                                          
                                          
                                          5,173
                                          
                                          
                                          
                                          4.09
                                          
                                          
                                          
                                          82,717
                                          
                                          
                                          
                                          4,185
                                          
                                          
                                          
                                          5.06
                                          
                                          
                                          
                                          86,183
                                          
                                          
                                          
                                          4,176
                                          
                                          
                                          
                                          4.85Total
      interest-bearing liabilities
                                          
                                          
                                          665,828
                                          
                                          
                                          
                                          22,406
                                          
                                          
                                          
                                          3.37
                                          
                                          
                                          
                                          618,126
                                          
                                          
                                          
                                          26,500
                                          
                                          
                                          
                                          4.29
                                          
                                          
                                          
                                          586,808
                                          
                                          
                                          
                                          22,279
                                          
                                          
                                          
                                          3.80Noninterest-bearing
      deposits
                                          
                                          
                                          40,647
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          39,893
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          35,310Noninterest-bearing
      liabilities
                                          
                                          
                                          8,162
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          10,282
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          9,781Total
      liabilities
                                          
                                          
                                          714,637
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          668,301
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          631,899Stockholders’
      equity
                                          
                                          
                                          85,232
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          84,784
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          85,035Total
      liabilities and equity
                                          
                                          $
                                          799,869
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          753,085
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          716,934Net interest
      income(1)
                                          
                                          
                                          
                                          
                                          
                                          $
                                          20,718
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          20,792
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          20,831Interest rate
      spread(3)
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          2.69
                                          %
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          2.84
                                          %
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          3.10
                                          %Net interest
      margin(4)
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          2.91
                                          %
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          3.14
                                          %
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          3.33
                                          %Ratio
      of average interest-earning assets to avg. int.-bearing
      liabilities
                                          
                                          
                                          
                                          
                                          
                                          
                                          106.89
                                          %
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          107.26
                                          %
                                          
                                          
                                          
                                          
                                          
                                          
                                          106.53
                                          %
 
 (1)
              Yields
      and interest income on tax-exempt investments and loans have been adjusted
      on a fully taxable-equivalent basis using the federal tax rate of
      34%.  The taxable equivalent adjustments were $516,000,
      $557,000, and $191,000, for the years 2008, 2007 and 2006,
      respectively.
 (2)
              Average
      loan balances include nonaccrual
loans.
 (3)
              Interest
      rate spread represents the difference between the average yield on
      interest-earning assets and the average cost of interest-earning
      liabilities.
 (4)
              Net
      interest margin is calculated by dividing net interest income by total
      average interest-earning
assets.
  28
 
 Changes
in interest income and expense can result from changes in both volume and rates.
The following table sets forth information regarding changes in our interest
income and interest expense for the periods indicated. For each category of our
interest-earning assets and interest-bearing liabilities, information is
provided on changes attributable to (i) changes in volume (changes in volume
multiplied by old rate); (ii) changes in rate (changes in rate multiplied by old
volume); and (iii) the net change.  The changes attributable to the
combined impact of volume and rate have been allocated proportionately to the
changes due to volume and the changes due to rate.
 
 Volume
and Rate Variance Analysis
 
 For The Year Ended
                      
                      
                      For the Year EndedDecember 31, 2008 vs. December 31, 2007
                      
                      
                      December 31, 2007 vs. December 31, 2006Increase (Decrease) Due to
                      
                      
                      Increase (Decrease) Due to(Dollars in Thousands)
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      Total
                      
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      TotalInterest
      income:Loans
      receivable
                      
                      $
                      7,156
                      
                      
                      $
                      (10,554
                      )
                      
                      $
                      (3,398
                      )
                      
                      $
                      2,584
                      
                      
                      $
                      647
                      
                      
                      $
                      3,231Interest-bearing
      bank deposits
                      
                      
                      (101
                      )
                      
                      
                      (189
                      )
                      
                      
                      (298
                      )
                      
                      
                      (347
                      )
                      
                      
                      (45
                      )
                      
                      
                      (392
                      )Investment
      securities
                      
                      
                      (1,596
                      )
                      
                      
                      253
                      
                      
                      
                      (1,343
                      )
                      
                      
                      551
                      
                      
                      
                      488
                      
                      
                      
                      1,039Mortgage-backed
      securities
                      
                      
                      651
                      
                      
                      
                      212
                      
                      
                      
                      863
                      
                      
                      
                      2
                      
                      
                      
                      302
                      
                      
                      
                      304Total
      interest income
                      
                      
                      6,110
                      
                      
                      
                      (10,276
                      )
                      
                      
                      (4,176
                      )
                      
                      
                      2,790
                      
                      
                      
                      1,392
                      
                      
                      
                      4,182Interest
      expense:Deposits
                      
                      
                      (69
                      )
                      
                      
                      (5,013
                      )
                      
                      
                      (5,082
                      )
                      
                      
                      1,593
                      
                      
                      
                      2,619
                      
                      
                      
                      4,212Borrowed
      funds
                      
                      
                      1,550
                      
                      
                      
                      (562
                      )
                      
                      
                      988
                      
                      
                      
                      (92
                      )
                      
                      
                      101
                      
                      
                      
                      9Total
      interest expense
                      
                      
                      1,481
                      
                      
                      
                      (5,575
                      )
                      
                      
                      (4,095
                      )
                      
                      
                      1,501
                      
                      
                      
                      2,720
                      
                      
                      
                      4,221Net
      interest income increase (decrease)
                      
                      $
                      4,629
                      
                      
                      $
                      (4,701
                      )
                      
                      $
                      (72
                      )
                      
                      $
                      1,289
                      
                      
                      $
                      (1,328
                      )
                      
                      $
                      (39
                      )
 
 Lending
Activities
 
 The
Company generally makes commercial real estate loans, commercial business loans,
consumer loans, and residential mortgage loans within its market
area.  In the past, we concentrated our lending activities on
conventional first mortgage loans secured by one-to-four family properties.
However, since converting to a stock company in 1998, the Company has focused
more of its lending activities on construction loans, nonresidential real estate
loans, commercial business loans and consumer loans. A substantial portion of
our loan portfolio is secured by real estate, either as primary or secondary
collateral, located in our primary market area.  The Company has a
diversified loan portfolio with no material concentrations to any one borrower
or industry.  The Company has not been an originator or purchaser of
option adjustable rate or “no documentation” portfolio loans and the Company’s
loan portfolio does not include any mortgage loans that are considered
“sub-prime.”
 
 Our
lending activities are subject to the written, non-discriminatory, underwriting
standards and loan origination procedures established by management and approved
by our Board of Directors. Loan originations come from a number of sources
including real estate agents, home builders, walk-in customers, referrals and
existing customers.  Loan officers also call on local businesses
soliciting commercial products. We advertise our loan products in various print
media including local newspapers as well as the Company’s website. In our
marketing, we emphasize our community ties, personalized customer service, and
an efficient underwriting and approval process. All real estate collateral is
appraised or evaluated in accordance with regulatory requirements.  On
new loan originations, we require hazard, title and, to the extent applicable,
flood insurance on all security property. The amounts and types of loans
outstanding over the past five years are shown on the following
table.
  29
  Loan
Portfolio Composition
 
 December 31, 2008
                              
                              
                              December 31, 2007
                              
                              
                              December 31, 2006Amount
                              
                              
                              Percent
                              
                              
                              Amount
                              
                              
                              Percent
                              
                              
                              Amount
                              
                              
                              Percent(Dollars
      in Thousands)Real
      estate loans:One-to-four
      family residential
                              
                              $
                              84,777
                              
                              
                              
                              13.53
                              %
                              
                              $
                              78,572
                              
                              
                              
                              14.03
                              %
                              
                              $
                              83.265
                              
                              
                              
                              16.16
                              %Multifamily
      residential
                              
                              
                              23,359
                              
                              
                              
                              3.73
                              
                              
                              
                              19,717
                              
                              
                              
                              3.52
                              
                              
                              
                              21,726
                              
                              
                              
                              4.22Construction
                              
                              
                              71,454
                              
                              
                              
                              11.40
                              
                              
                              
                              90,949
                              
                              
                              
                              16.24
                              
                              
                              
                              76,505
                              
                              
                              
                              14.85Nonresidential
                              
                              
                              298,255
                              
                              
                              
                              47.60
                              
                              
                              
                              254,782
                              
                              
                              
                              45.50
                              
                              
                              
                              231,265
                              
                              
                              
                              44.89Total
      real estate loans
                              
                              
                              477,845
                              
                              
                              
                              76.26
                              
                              
                              
                              444,020
                              
                              
                              
                              79.29
                              
                              
                              
                              412,761
                              
                              
                              
                              80.12Commercial
      business loans
                              
                              
                              34,451
                              
                              
                              
                              5.50
                              
                              
                              
                              33,583
                              
                              
                              
                              6.00
                              
                              
                              
                              32,202
                              
                              
                              
                              6.25Consumer
      loans
                              
                              
                              114,287
                              
                              
                              
                              18.24
                              
                              
                              
                              82,363
                              
                              
                              
                              14.71
                              
                              
                              
                              70,209
                              
                              
                              
                              13.63Total
      gross loans
                              
                              
                              626,583
                              
                              
                              
                              100.00
                              %
                              
                              
                              559,966
                              
                              
                              
                              100.00
                              %
                              
                              
                              515,172
                              
                              
                              
                              100.00
                              %Less:Deferred
      loan fees (costs), net
                              
                              
                              (105
                              )
                              
                              
                              
                              
                              
                              
                              10
                              
                              
                              
                              
                              
                              
                              
                              (230
                              )Allowance
      for loan losses
                              
                              
                              8,026
                              
                              
                              
                              
                              
                              
                              
                              6,144
                              
                              
                              
                              
                              
                              
                              
                              5,764Total
      loans, net
                              
                              $
                              618,662
                              
                              
                              
                              
                              
                              
                              $
                              553,812
                              
                              
                              
                              
                              
                              
                              $
                              509,638
 
 December 31, 2005
                                                              
                                                              
                                                              December 31, 2004Amount
                                                              
                                                              
                                                              Percent
                                                              
                                                              
                                                              Amount
                                                              
                                                              
                                                              Percent(Dollars
      in Thousands)Real
      estate loans:One-to-four
      family residential
                                                              
                                                              $
                                                              98,635
                                                              
                                                              
                                                              
                                                              20.83
                                                              %
                                                              
                                                              $
                                                              91,714
                                                              
                                                              
                                                              
                                                              28.92
                                                              %Multifamily
      residential
                                                              
                                                              
                                                              24,594
                                                              
                                                              
                                                              
                                                              5.19
                                                              
                                                              
                                                              
                                                              10,632
                                                              
                                                              
                                                              
                                                              3.35Construction
                                                              
                                                              
                                                              62,687
                                                              
                                                              
                                                              
                                                              13.24
                                                              
                                                              
                                                              
                                                              25,033
                                                              
                                                              
                                                              
                                                              7.89Nonresidential
                                                              
                                                              
                                                              185,319
                                                              
                                                              
                                                              
                                                              39.13
                                                              
                                                              
                                                              
                                                              114,551
                                                              
                                                              
                                                              
                                                              36.12Total
      real estate loans
                                                              
                                                              
                                                              371,235
                                                              
                                                              
                                                              
                                                              78.39
                                                              
                                                              
                                                              
                                                              241,930
                                                              
                                                              
                                                              
                                                              76.28Commercial
      business loans
                                                              
                                                              
                                                              30,128
                                                              
                                                              
                                                              
                                                              6.36
                                                              
                                                              
                                                              
                                                              14,002
                                                              
                                                              
                                                              
                                                              4.41Consumer
      loans
                                                              
                                                              
                                                              72,237
                                                              
                                                              
                                                              
                                                              15.25
                                                              
                                                              
                                                              
                                                              61,245
                                                              
                                                              
                                                              
                                                              19.31Total
      gross loans
                                                              
                                                              
                                                              473,600
                                                              
                                                              
                                                              
                                                              100.00
                                                              %
                                                              
                                                              
                                                              317,177
                                                              
                                                              
                                                              
                                                              100.00
                                                              %Less:Deferred
      loan fees, net
                                                              
                                                              
                                                              264
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              21Allowance
      for loan losses
                                                              
                                                              
                                                              5,104
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              3,029Total
      loans, net
                                                              
                                                              $
                                                              468,232
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              314,127
 
 Our Board
of Directors must approve all loans in excess of $3.5 million, or in any amount
to borrowers with existing exposure to us in excess of $3.5 million, or in any
amount that when added to the borrower’s existing exposure to us causes such
total exposure to be in excess of $3.5 million.   In addition,
all unsecured loans in excess of $500,000, or in any amount that when added to a
borrower’s existing unsecured exposure to us causes such unsecured exposure to
be in excess of $500,000, must be approved by our Board of
Directors.  Loans of $3.5 million or less, or customers with exposure
(including the proposed loan) of $3.5 million or less, or unsecured loans of
$500,000 or less, or customers with unsecured exposure (including the proposed
loan) of $500,000 or less, as applicable, may be approved individually or
jointly by our lending officers within loan approval limits delegated by our
Board of Directors.  In addition, the Board of Directors has delegated
“incremental” loan approval limits to certain lending officers which allow them
to approve a new loan to an existing customer in an amount equal to, or less
than, their incremental loan limit that would otherwise require approval by the
Board of Directors or the additional approval of another lending officer. Any
loan approved by a lending officer using their incremental loan limit must be
ratified by the Board of Directors or approved by another lending officer, as
applicable, after the loan has been made.
 
 The
following table represents the maturity distribution of the Company's loans by
type, including fixed-rate loans, as of December 31, 2008. Demand loans, loans
having no stated schedule of repayments and no stated maturity, and overdrafts
are reported as becoming due within one year. Loan balances do not include
undisbursed loan proceeds, unearned discounts, unearned income and allowance for
loan losses.
  30
 
 Maturity
Distribution of Loan Portfolio
 
 One year
                  
                  
                  One to
                  
                  
                  Over Fiveor Less
                  
                  
                  Five Years
                  
                  
                  Years
                  
                  
                  Total(in
      thousands)Real
      Estate:One-to-four
      family residential
                  
                  $
                  2,482
                  
                  
                  $
                  4,689
                  
                  
                  $
                  77,606
                  
                  
                  $
                  84,777Multifamily
      residential
                  
                  
                  1,738
                  
                  
                  
                  12,187
                  
                  
                  
                  9,434
                  
                  
                  
                  23,359Construction
                  
                  
                  44,208
                  
                  
                  
                  24,591
                  
                  
                  
                  2,655
                  
                  
                  
                  71,454Nonresidential
                  
                  
                  106,386
                  
                  
                  
                  157,130
                  
                  
                  
                  34,739
                  
                  
                  
                  298,255Total
      real estate loans
                  
                  
                  154,814
                  
                  
                  
                  198,597
                  
                  
                  
                  124,434
                  
                  
                  
                  477,845Commercial
      business
                  
                  
                  18,776
                  
                  
                  
                  14,663
                  
                  
                  
                  1,012
                  
                  
                  
                  34,451Consumer
                  
                  
                  1,210
                  
                  
                  
                  26,461
                  
                  
                  
                  86,616
                  
                  
                  
                  114,287Total
      gross loans
                  
                  $
                  174,800
                  
                  
                  $
                  239,721
                  
                  
                  $
                  212,062
                  
                  
                  $
                  626,583
 
 The following table sets forth the
dollar amount of all loans as of December 31, 2008, for which final payment is
not due until after December 31, 2008.  The table also shows the
amount of each type of loan that has a fixed rate of interest and those that
have an adjustable rate of interest.
 
 Interest
Rate Distribution of Loan Portfolio
 
 Fixed Rates
                    
                    
                    Adjustable Rates
                    
                    
                    Total(in thousands)Real
      Estate Loans:One-to-four
      family residential
                    
                    $
                    24,669
                    
                    
                    $
                    57,626
                    
                    
                    $
                    82,295Multifamily
      residential
                    
                    
                    11,893
                    
                    
                    
                    9,728
                    
                    
                    
                    21,621Construction
                    
                    
                    19,105
                    
                    
                    
                    8,141
                    
                    
                    
                    27,246Nonresidential
                    
                    
                    135,193
                    
                    
                    
                    56,677
                    
                    
                    
                    191,870Total
      real estate loans
                    
                    
                    190,860
                    
                    
                    
                    132,172
                    
                    
                    
                    323,032Commercial
      business
                    
                    
                    13,105
                    
                    
                    
                    2,570
                    
                    
                    
                    15,675Consumer
      loans
                    
                    
                    22,749
                    
                    
                    
                    90,327
                    
                    
                    
                    113,076Total
      gross loans
                    
                    $
                    226,714
                    
                    
                    $
                    225,069
                    
                    
                    $
                    451,783
 
 Scheduled
contractual principal repayments of loans do not reflect the actual life of such
assets. The average life of a loan is substantially less than its contractual
terms because of prepayments. In addition, due-on-sale clauses on loans
generally give us the right to declare loans immediately due and payable in the
event, among other things, that the borrower sells the real property subject to
the mortgage and the loan is not repaid. The average life of mortgage loans
tends to increase, however, when current mortgage loan market rates are
substantially higher than rates on existing mortgage loans and, conversely,
decrease when rates on existing mortgage loans are substantially higher than
current mortgage loan market rates.
 
 Nonperforming Assets and
Delinquencies.When a borrower fails to make a required payment on a
loan, we attempt to cure the deficiency by contacting the borrower and
collecting the payment. Computer generated late notices are mailed 15 days after
a payment is due. In most cases, deficiencies are cured promptly. If a
delinquency continues, additional contact is made either through a notice or
other means and we will attempt to work out a payment schedule and actively
encourage delinquent residential mortgage borrowers to seek home ownership
counseling. While we generally prefer to work with borrowers to resolve such
problems, we will institute foreclosure or other proceedings, as necessary, to
minimize any potential loss. Loans are placed on nonaccrual status generally if,
in the opinion of management, principal or interest payments are not likely in
accordance with the terms of the loan agreement, such as when principal or
interest is past due 90 days or more.  Interest accrued but not
collected at the date the loan is placed on nonaccrual status is reversed
against income in the current period. Loans may be reinstated to accrual status
when payments are under 90 days past due or, in the opinion of management,
collection of the remaining past due balances can be reasonably expected. Our
Board of Directors is informed monthly of the total amount of loans which are
more than 30 days delinquent.  Loans that are more than 90 days
delinquent or in foreclosure are reviewed by the Board on an individual basis
each month.
  31
 
 The
following table sets forth information with respect to our nonperforming assets
at the dates indicated.
 
 Nonperforming
Assets
 December 31,2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004(Dollars
      in thousands)Loans
      accounted for on a nonaccrual basis:Real
      estate loans:One-to-four
      family residential
                    
                    $
                    199
                    
                    
                    $
                    159
                    
                    
                    $
                    473
                    
                    
                    $
                    681
                    
                    
                    $
                    627Multifamily
      residential
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Construction
                    
                    
                    693
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    956
                    
                    
                    
                    -Nonresidential
      real estate
                    
                    
                    1,310
                    
                    
                    
                    520
                    
                    
                    
                    888
                    
                    
                    
                    397
                    
                    
                    
                    209Commercial
      business
                    
                    
                    -
                    
                    
                    
                    146
                    
                    
                    
                    78
                    
                    
                    
                    274
                    
                    
                    
                    30Consumer
                    
                    
                    698
                    
                    
                    
                    221
                    
                    
                    
                    360
                    
                    
                    
                    243
                    
                    
                    
                    80Total
      nonaccrual loans
                    
                    
                    2,900
                    
                    
                    
                    1,046
                    
                    
                    
                    1,799
                    
                    
                    
                    2,551
                    
                    
                    
                    946Accruing
      loans which were contractually past due 90 days or more
                    
                    
                    132
                    
                    
                    
                    766
                    
                    
                    
                    1,212
                    
                    
                    
                    -
                    
                    
                    
                    -Total
      nonperforming loans
                    
                    
                    3,032
                    
                    
                    
                    1,812
                    
                    
                    
                    3,011
                    
                    
                    
                    2,551
                    
                    
                    
                    946Real
      estate owned
                    
                    
                    2,601
                    
                    
                    
                    529
                    
                    
                    
                    139
                    
                    
                    
                    1,157
                    
                    
                    
                    806Total
      nonperforming assets
                    
                    $
                    5,633
                    
                    
                    $
                    2,341
                    
                    
                    $
                    3,150
                    
                    
                    $
                    3,708
                    
                    
                    $
                    1,752Nonperforming
      loans to total loans
                    
                    
                    0.48
                    %
                    
                    
                    0.32
                    %
                    
                    
                    0.58
                    %
                    
                    
                    0.54
                    %
                    
                    
                    0.30
                    %Nonperforming
      assets to total assets
                    
                    
                    0.69
                    %
                    
                    
                    0.30
                    %
                    
                    
                    0.42
                    %
                    
                    
                    0.53
                    %
                    
                    
                    0.34
                    %Nonperforming
      assets to total loans
                    
                    
                    0.90
                    %
                    
                    
                    0.42
                    %
                    
                    
                    0.61
                    %
                    
                    
                    0.78
                    %
                    
                    
                    0.55
                    %
 
 Real Estate Acquired in Settlement of
Loans. Real estate acquired by us as a result of foreclosure or by
deed-in-lieu of foreclosure is classified as real estate acquired in settlement
of loans until sold.  Generally, foreclosed assets are held for sale
and such assets are carried at the lower of cost or market value minus estimated
cost to sell the property. After the date of acquisition, all costs incurred in
maintaining the property are expensed and costs incurred for the improvement or
development of such property are capitalized up to the extent of their net
realizable value.  At December 31, 2008, we had $2.6 million in real
estate acquired in settlement of loans.  This balance is comprised of
12 single-family residences, two residential lots, and one commercial office
building located in the Bank's normal lending area.   These
properties are in various stages of disposition.
 
 Restructured
Loans.  Under accounting principles generally accepted in the
United States of America, we are required to account for certain loan
modifications or restructurings as “troubled debt restructurings.” In general,
the modification or restructuring of a debt constitutes a troubled debt
restructuring if we, for economic or legal reasons related to the borrower’s
financial difficulties, grant a concession to the borrowers that we would not
otherwise consider. Debt restructurings or loan modifications for a borrower do
not necessarily always constitute troubled debt restructurings, however, and
troubled debt restructurings do not necessarily result in nonaccrual loans. As
of December 31, 2008, we had three restructured loans totaling $2.0 million
within the meaning of SFAS No. 15 “Accounting by Debtors and Creditors
for Troubled Debt Restructuring.”
  32
  Asset Classification. The OTS
has adopted various regulations regarding problem assets of financial
institutions. The regulations require that each insured institution review and
classify its assets on a regular basis. In addition, in connection with
examinations of insured institutions, OTS examiners have the authority to
identify problem assets and, if appropriate, require them to be classified.
There are three classifications for problem assets: substandard, doubtful and
loss. Substandard assets have one or more defined weaknesses and are
characterized by the distinct possibility that the insured institution will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full on the basis of currently
existing facts, conditions and values questionable, and there is a high
possibility of loss. An asset classified as loss is considered uncollectible and
of such little value that continuance as an asset of the institution is not
warranted. If an asset or portion thereof is classified as loss, we establish
specific allowances for loan losses for the full amount of the portion of the
asset classified as loss. All or a portion of general loan loss allowances
established to cover possible losses related to assets classified substandard or
doubtful can be included in determining an institution’s regulatory capital,
while specific valuation allowances for loan losses generally do not qualify as
regulatory capital. Assets that do not currently expose the insured institution
to sufficient risk to warrant classification in one of the aforementioned
categories but possess weaknesses are designated “special mention.”
 
 As of
December 31, 2008, we had $11.9 million of assets classified as substandard,
$1.9 million of assets classified as doubtful and no loans classified as loss.
The aggregate amount designated special mention as of December 31, 2008, was
$16.0 million.  Pursuant to SFAS No. 114, “Accounting by Creditors for
Impairment of a Loan,”management determined that there were 11 impaired
loans totaling $5.9 million as of December 31, 2008.  Based on an
analysis of the underlying collateral of the loans, the overall economic
conditions, discussions with the borrowers, and the historical performance of
the loan, management created specific reserves totaling $871,000 for these
loans.
 
 As of
December 31, 2007, we had $3.4 million in assets classified substandard and no
assets classified as either doubtful or loss. The aggregate amount designated
special mention as of December 31, 2007, was $7.8 million. Pursuant to SFAS No.
114, management determined that impaired loans were not material as of December
31, 2007.
 
 Allowance
for Loan Losses
 
 Management
has established a systematic methodology for evaluating the adequacy of the
Company’s allowance for loan losses.  The 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
under SFAS 114. 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.
 
 At
December 31, 2008, we had an allowance for loan losses of $8.0
million.  Management believes that this amount meets the requirement
for losses on loans that management considers to be impaired, for known losses,
and for risks inherent in the remaining loan portfolios.  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 allowance
for loan losses is subject to periodic evaluation by various regulatory
authorities and may be subject to adjustment upon their examination. The
following table sets forth an analysis of our allowance for loan
losses.
  33
  Loan
Loss and Recovery Experience
 At or for the Year Ended December
      31,2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004(Dollars
      in Thousands)Allowance
      for loan losses at beginning of year
                    
                    $
                    6,144
                    
                    
                    $
                    5,764
                    
                    
                    $
                    5,104
                    
                    
                    $
                    3,029
                    
                    
                    $
                    2,969Loans
      Charge-offs:One-to-four
      family residential
                    
                    
                    185
                    
                    
                    
                    1
                    
                    
                    
                    -
                    
                    
                    
                    5
                    
                    
                    
                    14Multifamily
      residential
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Construction
                    
                    
                    203
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Nonresidential
      mortgage loans
                    
                    
                    319
                    
                    
                    
                    309
                    
                    
                    
                    -
                    
                    
                    
                    182
                    
                    
                    
                    174Commercial
      business loans
                    
                    
                    586
                    
                    
                    
                    861
                    
                    
                    
                    484
                    
                    
                    
                    158
                    
                    
                    
                    76Consumer
      loans
                    
                    
                    167
                    
                    
                    
                    83
                    
                    
                    
                    89
                    
                    
                    
                    76
                    
                    
                    
                    14Total
      charge-offs
                    
                    
                    1,460
                    
                    
                    
                    1,254
                    
                    
                    
                    573
                    
                    
                    
                    421
                    
                    
                    
                    278Recoveries
      of loans previously charged-off:One-to-four
      family residential
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Multifamily
      family residential
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Construction
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Nonresidential
      mortgage loans
                    
                    
                    11
                    
                    
                    
                    -
                    
                    
                    
                    50
                    
                    
                    
                    5
                    
                    
                    
                    1Commercial
      business loans
                    
                    
                    46
                    
                    
                    
                    296
                    
                    
                    
                    8
                    
                    
                    
                    14
                    
                    
                    
                    4Consumer
      loans
                    
                    
                    10
                    
                    
                    
                    48
                    
                    
                    
                    10
                    
                    
                    
                    2
                    
                    
                    
                    3Total
      recoveries
                    
                    
                    67
                    
                    
                    
                    344
                    
                    
                    
                    68
                    
                    
                    
                    21
                    
                    
                    
                    8Net
      charge-offs
                    
                    
                    1,393
                    
                    
                    
                    910
                    
                    
                    
                    505
                    
                    
                    
                    400
                    
                    
                    
                    270Provision
      for loan losses
                    
                    
                    3,275
                    
                    
                    
                    1,290
                    
                    
                    
                    1,165
                    
                    
                    
                    985
                    
                    
                    
                    330Allowance
      acquired in acquisition
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,490
                    
                    
                    
                    -Allowance
      for loan losses at end of year
                    
                    $
                    8,026
                    
                    
                    $
                    6,144
                    
                    
                    $
                    5,764
                    
                    
                    $
                    5,104
                    
                    
                    $
                    3,029Ratios:Allowance
      for loan losses to total loans
                    
                    
                    1.28
                    %
                    
                    
                    1.10
                    %
                    
                    
                    1.12
                    %
                    
                    
                    1.08
                    %
                    
                    
                    0.95
                    %Net
      charge-offs to average loans
                    
                    
                    0.23
                    %
                    
                    
                    0.17
                    %
                    
                    
                    0.10
                    %
                    
                    
                    0.12
                    %
                    
                    
                    0.09
                    %
 
 The
following table sets forth the breakdown of the allowance for loan losses by
loan category at the dates indicated. Management believes that the allowance can
be allocated by category only on an approximate basis. The allocation of the
allowance to each category is not necessarily indicative of future losses and
does not restrict the use of the allowance to absorb losses in any other
category.
  34
  Allocation
of the Allowance for Loan Losses
 
 December 31, 2008
                  
                  
                  December 31, 2007
                  
                  
                  December 31, 2006% of
                  
                  
                  
                  
                  
                  % of
                  
                  
                  
                  
                  
                  % ofAmount
                  
                  
                  Total Loans
                  
                  
                  Amount
                  
                  
                  Total Loans
                  
                  
                  Amount
                  
                  
                  Total Loans(Dollars
      in Thousands)Real
      estate loans:One-to-four
      family residential
                  
                  $
                  275
                  
                  
                  
                  13.53
                  %
                  
                  $
                  250
                  
                  
                  
                  14.03
                  %
                  
                  $
                  300
                  
                  
                  
                  16.16
                  %Multifamily
      residential
                  
                  
                  225
                  
                  
                  
                  3.73
                  
                  
                  
                  200
                  
                  
                  
                  3.52
                  
                  
                  
                  250
                  
                  
                  
                  4.22Construction
                  
                  
                  1,500
                  
                  
                  
                  11.40
                  
                  
                  
                  900
                  
                  
                  
                  16.24
                  
                  
                  
                  750
                  
                  
                  
                  14.85Nonresidential
                  
                  
                  3,026
                  
                  
                  
                  47.60
                  
                  
                  
                  2,494
                  
                  
                  
                  45.50
                  
                  
                  
                  2,264
                  
                  
                  
                  44.89Total
      real estate loans
                  
                  
                  5,026
                  
                  
                  
                  76.26
                  
                  
                  
                  3,844
                  
                  
                  
                  79.29
                  
                  
                  
                  3,564
                  
                  
                  
                  80.12Commercial
      business
                  
                  
                  1,250
                  
                  
                  
                  5.50
                  
                  
                  
                  1,000
                  
                  
                  
                  6.00
                  
                  
                  
                  1,000
                  
                  
                  
                  6.25Consumer
      loans
                  
                  
                  1,750
                  
                  
                  
                  18.24
                  
                  
                  
                  1,300
                  
                  
                  
                  14.71
                  
                  
                  
                  1,200
                  
                  
                  
                  13.63Total
      allowance for loan losses
                  
                  $
                  8,026
                  
                  
                  
                  100.00
                  %
                  
                  $
                  6,144
                  
                  
                  
                  100.00
                  %
                  
                  $
                  5,764
                  
                  
                  
                  100.00
                  %
 
 December 31, 2005
                        
                        
                        December 31, 2004% of
                        
                        
                        
                        
                        
                        % ofAmount
                        
                        
                        Total Loans
                        
                        
                        Amount
                        
                        
                        Total Loans(Dollars
      in Thousands)Real
      estate loans:One-to-four
      family residential
                        
                        $
                        300
                        
                        
                        
                        20.83
                        %
                        
                        $
                        250
                        
                        
                        
                        28.92
                        %Multifamily
      residential
                        
                        
                        250
                        
                        
                        
                        5.19
                        
                        
                        
                        100
                        
                        
                        
                        3.35Construction
                        
                        
                        500
                        
                        
                        
                        13.24
                        
                        
                        
                        300
                        
                        
                        
                        7.89Nonresidential
                        
                        
                        1,854
                        
                        
                        
                        39.13
                        
                        
                        
                        609
                        
                        
                        
                        36.12Total
      real estate loans
                        
                        
                        2,904
                        
                        
                        
                        78.39
                        
                        
                        
                        1,259
                        
                        
                        
                        76.28Commercial
      business
                        
                        
                        1,000
                        
                        
                        
                        6.36
                        
                        
                        
                        600
                        
                        
                        
                        4.41Consumer
      loans
                        
                        
                        1,200
                        
                        
                        
                        15.25
                        
                        
                        
                        1,170
                        
                        
                        
                        19.31Total
      allowance for loan losses
                        
                        $
                        5,104
                        
                        
                        
                        100.00
                        %
                        
                        $
                        3,029
                        
                        
                        
                        100.00
                        %
 
 Deposit
Activities
 
 Our
deposit products include a broad selection of deposit instruments, including
checking accounts, money market deposit accounts, savings accounts, individual
retirement accounts, and term certificate accounts. We offer these products to
both retail and commercial customers.  Deposit account terms vary with
the principal difference being the minimum balance deposit, early withdrawal
penalties and the interest rate. We review our deposit mix and pricing
weekly.  We believe that we are competitive in the type of accounts
and interest rates we offer on our deposit products. We do not seek to pay the
highest deposit rates, but a competitive rate. Management determines the rates
paid based on a number of conditions, including rates paid by competitors, rates
on U.S. Treasury securities, rates offered on alternative lending programs, and
the deposit growth rate we are seeking to achieve. The following table sets
forth information concerning our deposit accounts.
  35
  Deposit
Portfolio Composition
 
 December 31, 2008
                  
                  
                  December 31, 2007
                  
                  
                  December 31, 2006Average
                  
                  
                  
                  
                  
                  Average
                  
                  
                  
                  
                  
                  AverageActual
                  
                  
                  Interest
                  
                  
                  Actual
                  
                  
                  Interest
                  
                  
                  Actual
                  
                  
                  InterestCategory
                  
                  Balance
                  
                  
                  Rate
                  
                  
                  Balance
                  
                  
                  Rate
                  
                  
                  Balance
                  
                  
                  Rate(Dollars
      in Thousands)Noninterest
      bearing demand
                  
                  $
                  44,971
                  
                  
                  
                  -
                  %
                  
                  $
                  43,571
                  
                  
                  
                  -
                  %
                  
                  $
                  37,762
                  
                  
                  
                  -
                  %Interest
      bearing demand
                  
                  
                  77,760
                  
                  
                  
                  1.5
                  
                  
                  
                  58,410
                  
                  
                  
                  1.7
                  
                  
                  
                  52,778
                  
                  
                  
                  1.3Money
      market deposit
                  
                  
                  103,271
                  
                  
                  
                  2.3
                  
                  
                  
                  129,687
                  
                  
                  
                  3.9
                  
                  
                  
                  117,633
                  
                  
                  
                  3.8Savings
      accounts
                  
                  
                  10,708
                  
                  
                  
                  0.4
                  
                  
                  
                  12,038
                  
                  
                  
                  0.6
                  
                  
                  
                  16,027
                  
                  
                  
                  0.8Certificates
      of deposit
                  
                  
                  344,778
                  
                  
                  
                  3.9
                  
                  
                  
                  347,059
                  
                  
                  
                  4.8
                  
                  
                  
                  338,602
                  
                  
                  
                  4.1Total
      Deposits
                  
                  $
                  581,488
                  
                  
                  
                  3.0
                  %
                  
                  $
                  590,765
                  
                  
                  
                  3.9
                  %
                  
                  $
                  562,802
                  
                  
                  
                  3.4
                  %
 
 The
following table indicates the amount of our time deposits (also referred to as
certificates of deposits) with a principal balance greater than $100,000 by time
remaining until maturity as of December 31, 2008.
 
 Maturities
of Time Deposits over $100,000
 
 Maturity Period
                    
                    2008(Dollars in Thousands)Within
      three months
                    
                    $
                    30,045Over
      three to six months
                    
                    
                    41,219Over
      six to twelve months
                    
                    
                    41,040Over
      twelve months
                    
                    
                    15,463Total
      time deposits over $100,000
                    
                    $
                    127,767
 
 The
following table sets forth the amount of time deposits in the Bank categorized
by rates as of December 31 at the dates indicated.
 
 Time
Deposit Interest Rate Composition
  Interest
      Rate
              
              2008
              
              
              2007
              
              
              2006(Dollars
      in Thousands)Less
      than 2.00%
              
              $
              21,251
              
              
              $
              599
              
              
              $
              9402.01
      to 4.00%
              
              
              283,990
              
              
              
              51,520
              
              
              
              69,4064.01
      to 6.00%
              
              
              39,537
              
              
              
              294,940
              
              
              
              268,2566.01
      to 8.00%
              
              
              -
              
              
              
              -
              
              
              
              -$
              344,778
              
              
              $
              347,059
              
              
              $
              338,602
  36
  The
following table sets forth the amount of time deposits in the Bank categorized
by rates and maturities at December 31, 2008.
 
 Time
Deposit Maturity Schedule
 During the Years Ended December
      31,2012Interest Rate
                
                2009
                
                
                2010
                
                
                2011
                
                
                or Later
                
                
                Total(Dollars
      in Thousands)Less
      than 2.0%
                
                $
                21,251
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                21,2512.01
      to 4.0%
                
                
                262,959
                
                
                
                18,458
                
                
                
                1,936
                
                
                
                637
                
                
                
                283,9904.01
      to 6.0%
                
                
                26,111
                
                
                
                6,992
                
                
                
                6,185
                
                
                
                249
                
                
                
                39,537Total
                
                $
                310,321
                
                
                $
                25,450
                
                
                $
                8,121
                
                
                $
                886
                
                
                $
                344,778
 
 Capital
Adequacy and Resources
 
 OTS
regulations require savings banks to meet three minimum capital standards: a
1.5% tangible capital ratio, a 4% leverage ratio and an 8% risk-based capital
ratio.  At December 31, 2008, Citizens South Bank’s capital exceeded
all applicable requirements. Under prompt corrective action regulations, the OTS
is required and authorized to take supervisory actions against undercapitalized
savings banks. For this purpose, a savings bank is placed in one of the
following five categories based on the bank’s capital: 1) well-capitalized (at
least 5% leverage capital, 6% tier 1 risk-based capital and 10% total risk-based
capital); 2) adequately capitalized (at least 4% leverage capital, 4% tier 1
risk-based capital and 8% total risk-based capital); 3) undercapitalized (less
than 8% total risk-based capital, 4% tier 1 risk-based capital or 3% leverage
capital); 4) significantly undercapitalized (less than 6% total risk-based
capital, 3% tier 1 risk-based capital or 3% leverage capital); and 5)
critically undercapitalized (less than 2% tangible capital). At December 31,
2008, Citizens South Bank met the criteria for being considered
“well-capitalized.”
 
 Funding
for future growth is dependent upon the earnings of the Company and its
subsidiaries.  At December 31, 2008, the Company had a
capital-to-assets ratio of 12.81%.  As such, the Company fully expects
to be able to meet future capital needs caused by growth and expansion as well
as regulatory requirements.
 
 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 in brokered deposits and borrowings, including Federal Home Loan Bank
(“FHLB”) advances.  At December 31, 2008, the Company had
approximately $130 million in additional advances available from its line of
credit from 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,
the U.S. Government) 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 may also solicit brokered deposits for
providing funds for asset growth.
  37
 
 Off-Balance
Sheet Arrangements and Contractual Obligations
 
 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 December 31, 2008, the Company had
loan commitments of $15.5 million, investment commitments of $3.0 million, $4.1
million in undisbursed construction loan proceeds, and unused lines of credit of
$103.6 million. The Company believes that it has adequate resources to fund loan
commitments and lines of credit as they arise.  The Company does not
have any special purpose entities or other similar forms of off-balance sheet
financing.
 
 Under
existing contractual obligations, the Company will be required to make payments
in future periods.  The following table presents aggregated
information about payments due under such contractual obligations at December
31, 2008.  The Company expects that a portion of the deposits will not
be renewed upon maturity.  If there is a higher than normal level of
time deposits that are not renewed at maturity, then the Company may experience
a decrease in liquidity.  This may result in the Company offering
higher than market interest rates to maintain deposits, which would increase
interest expense.  Transaction deposit accounts with indeterminate
maturities have been classified as having payments due in one year or
less.
 
 Contractual
Maturities
  Payments Due by Period at December 31,
      2008One
      Year
              
              
              One
      to
              
              
              Over
      Three
              
              
              Over
      FiveOr Less
              
              
              Three Years
              
              
              to Five Years
              
              
              Years
              
              
              Total(Dollars
      in Thousands)Borrowed
      Funds
              
              $
              26,401
              
              
              $
              24,500
              
              
              $
              33,000
              
              
              $
              40,464
              
              
              $
              124,365Deposits
              
              
              547,030
              
              
              
              33,571
              
              
              
              887
              
              
              
              -
              
              
              
              581,488Lease
      Obligations
              
              
              466
              
              
              
              795
              
              
              
              512
              
              
              
              2,176
              
              
              
              3,949Total
              
              $
              573,897
              
              
              $
              58,866
              
              
              $
              34,399
              
              
              $
              42,640
              
              
              $
              709,802
  Management
of Market Risks
 
 Market
risk reflects the risk of economic loss resulting from adverse changes in market
prices and interest rates.  The risk of loss can be reflected in
diminished market values and/or reduced net interest income in future
periods.
 
 The
Company’s most significant form of market risk is interest rate risk, as the
majority of the Company's assets and liabilities are sensitive to changes in
interest rates.  The structure of the Company's loan and deposit
portfolios is such that significant declines in interest rates could adversely
impact net interest income.  The Company does not maintain a trading
account, nor is it subject to currency exchange risk or commodity price
risk.  The Company's Asset/Liability Committee ("ALCO") is responsible
for monitoring and managing exposure to interest rate risk, as discussed below
in "Interest Rate Sensitivity".
 
 Interest
Rate Sensitivity
 
 The
Company's ALCO monitors the Company's level of interest rate sensitivity and
ensures that the level of sensitivity of the Company's net portfolio value is
maintained within limits established by the Board of Directors. Through such
management, the ALCO seeks to reduce the vulnerability of the Company's
operations to changes in interest rates. During the past year, the ALCO utilized
the following strategies to manage interest rate risk: (1) emphasizing the
origination and retention of short-term commercial business loans and
nonresidential mortgage loans; (2) emphasizing the origination of
adjustable-rate home equity lines of credit; (3) emphasizing the origination and
retention of adjustable-rate one-to-four family residential mortgage loans; (4)
originating all new fixed-rate mortgage loans as a broker for a third party; and
(5) focusing on growing the Company’s core deposit portfolio.
  38
  
 The OTS
requires the computation of amounts by which the net present value of the Bank's
cash flow from assets, liabilities, and off balance sheet items (the Bank’s net
portfolio value or "NPV") and the net interest income (“NII”) of the Bank would
change in the event of a range of assumed changes in market interest rates.
These computations estimate the effect on a bank’s NPV and NII from
instantaneous and permanent one hundred- to three hundred-basis point increases
and decreases in market interest rates.  The following table presents
the Bank’s projected change in NPV and NII at December 31, 2008, as calculated
by an independent third party, based upon information provided by the
Bank.  The Bank’s level of sensitivity, given a hypothetical,
immediate, and sustained change in interest rates from + 300 basis points to –
300 basis points, is within the range of acceptable sensitivity established by
the Board of Directors and is detailed on the following table.
 
 Interest
Rate Sensitivity
 
 Hypothetical, Immediate,
                            
                            Estimated Theoretical
                            
                            
                            Estimated Theoreticaland Sustained
                            
                            Net Interest Income
                            
                            
                            Net Portfolio ValueChanges in Interest Rates
                            
                            Amount
                            
                            
                            %Change
                            
                            
                            Amount
                            
                            
                            %Change(Dollars
      in Thousands)300
      basis point rise
                            
                            $
                            22,645
                            
                            
                            
                            7.5
                            %
                            
                            $
                            113,737
                            
                            
                            
                            -11.5
                            %200
      basis point rise
                            
                            
                            22,175
                            
                            
                            
                            5.3
                            %
                            
                            
                            119,276
                            
                            
                            
                            -7.2
                            %100
      basis point rise
                            
                            
                            21,600
                            
                            
                            
                            2.6
                            %
                            
                            
                            124,513
                            
                            
                            
                            -3.2
                            %No
      change
                            
                            
                            21,063
                            
                            
                            
                            -
                            %
                            
                            
                            128,576
                            
                            
                            
                            -
                            %100
      basis point decline
                            
                            
                            21,330
                            
                            
                            
                            1.3
                            %
                            
                            
                            129,219
                            
                            
                            
                            0.5
                            %200
      basis point decline
                            
                            
                            21,621
                            
                            
                            
                            2.7
                            %
                            
                            
                            131,488
                            
                            
                            
                            2.3
                            %300
      basis point decline
                            
                            
                            19,836
                            
                            
                            
                            -5.8
                            %
                            
                            
                            138,963
                            
                            
                            
                            8.1
                            %
 
 Certain
shortcomings are inherent in the methodology used in the above interest rate
risk measurement.  Modeling changes in NPV require the making of
certain assumptions, which may or may not reflect the manner in which actual
yields and costs respond to changes in market interest rates.  In this
regard, the NPV table presented assumes that the composition of the interest
sensitive assets and liabilities existing at the beginning of a period remains
constant over the period being measured and also assumes that a particular
change in interest rates is reflected uniformly across the yield curve
regardless of the duration to maturity or repricing of specific assets and
liabilities.  Accordingly, although the NPV table provides an
indication of the Bank’s interest rate risk exposure at a particular point in
time, such measurements are not intended to and do not provide a precise
forecast of the effect of changes in market interest rates on the Bank’s net
interest income and will differ from actual results.
 
 Impact
of Inflation and Changing Prices
 
 The
consolidated financial statements and related notes have been prepared in
accordance with GAAP, which require the measurement of financial position and
operating results in terms of historical dollars, without considering the change
in the relative purchasing power of money over time due to
inflation.  Unlike most industrial companies, nearly all the assets
and liabilities of the Company are financial in nature.  As a result,
interest rates have a more significant impact on the Company’s performance than
the effect of inflation.  Interest rates do not necessarily change in
the same magnitude as the price of goods and services.
  39


Quarterly
Financial Data (unaudited)





First Quarter
                        
                        
                        Second Quarter
                        
                        
                        Third Quarter
                        
                        
                        Fourth Quarter(in Thousands, Except per Share Data)2008Interest
      income
                        
                        $
                        10,972
                        
                        
                        $
                        10,484
                        
                        
                        $
                        10,805
                        
                        
                        $
                        10,347Interest
      expense
                        
                        
                        6,185
                        
                        
                        
                        5,571
                        
                        
                        
                        5,423
                        
                        
                        
                        5,227Net
      interest income
                        
                        
                        4,787
                        
                        
                        
                        4,913
                        
                        
                        
                        5,382
                        
                        
                        
                        5,120Provision
      for loan losses
                        
                        
                        345
                        
                        
                        
                        750
                        
                        
                        
                        720
                        
                        
                        
                        1,460Net
      int. income after provision for loan losses
                        
                        
                        4,442
                        
                        
                        
                        4,163
                        
                        
                        
                        4,662
                        
                        
                        
                        3,660Noninterest
      income
                        
                        
                        1,680
                        
                        
                        
                        1,592
                        
                        
                        
                        1,492
                        
                        
                        
                        1,255Noninterest
      expense
                        
                        
                        4,882
                        
                        
                        
                        4,703
                        
                        
                        
                        5,145
                        
                        
                        
                        4,496Income
      before income taxes
                        
                        
                        1,240
                        
                        
                        
                        1,052
                        
                        
                        
                        1,009
                        
                        
                        
                        419Income
      taxes
                        
                        
                        270
                        
                        
                        
                        190
                        
                        
                        
                        187
                        
                        
                        
                        (8
                        )Net
      income
                        
                        $
                        970
                        
                        
                        $
                        862
                        
                        
                        $
                        822
                        
                        
                        $
                        427Per
      share data:Net
      income:Basic
                        
                        $
                        0.13
                        
                        
                        $
                        0.12
                        
                        
                        $
                        0.11
                        
                        
                        $
                        0.06Diluted
                        
                        
                        0.13
                        
                        
                        
                        0.12
                        
                        
                        
                        0.11
                        
                        
                        
                        0.06Cash
      dividends declared
                        
                        
                        0.085
                        
                        
                        
                        0.085
                        
                        
                        
                        0.085
                        
                        
                        
                        0.085Common
      stock price:High
                        
                        
                        11.03
                        
                        
                        
                        10.06
                        
                        
                        
                        8.24
                        
                        
                        
                        7.90Low
                        
                        
                        9.21
                        
                        
                        
                        7.42
                        
                        
                        
                        7.03
                        
                        
                        
                        5.752007Interest
      income
                        
                        $
                        11,365
                        
                        
                        $
                        11,585
                        
                        
                        $
                        11,943
                        
                        
                        $
                        11,842Interest
      expense
                        
                        
                        6,319
                        
                        
                        
                        6,513
                        
                        
                        
                        6,840
                        
                        
                        
                        6,829Net
      interest income
                        
                        
                        5,046
                        
                        
                        
                        5,072
                        
                        
                        
                        5,103
                        
                        
                        
                        5,013Provision
      for loan losses
                        
                        
                        330
                        
                        
                        
                        330
                        
                        
                        
                        300
                        
                        
                        
                        330Net
      int. income after provision for loan losses
                        
                        
                        4,716
                        
                        
                        
                        4,742
                        
                        
                        
                        4,803
                        
                        
                        
                        4,683Noninterest
      income
                        
                        
                        1,530
                        
                        
                        
                        1,988
                        
                        
                        
                        1,534
                        
                        
                        
                        1,511Noninterest
      expense
                        
                        
                        4,285
                        
                        
                        
                        4,617
                        
                        
                        
                        4,554
                        
                        
                        
                        4,439Income
      before income taxes
                        
                        
                        1,961
                        
                        
                        
                        2,113
                        
                        
                        
                        1,783
                        
                        
                        
                        1,755Income
      taxes
                        
                        
                        561
                        
                        
                        
                        524
                        
                        
                        
                        434
                        
                        
                        
                        428Net
      income
                        
                        $
                        1,400
                        
                        
                        $
                        1,589
                        
                        
                        $
                        1,349
                        
                        
                        $
                        1,327Per
      share data:Net
      income:Basic
                        
                        $
                        0.18
                        
                        
                        $
                        0.21
                        
                        
                        $
                        0.18
                        
                        
                        $
                        0.18Diluted
                        
                        
                        0.18
                        
                        
                        
                        0.20
                        
                        
                        
                        0.18
                        
                        
                        
                        0.18Cash
      dividends declared
                        
                        
                        0.08
                        
                        
                        
                        0.08
                        
                        
                        
                        0.08
                        
                        
                        
                        0.08Common
      stock price:High
                        
                        
                        13.40
                        
                        
                        
                        13.00
                        
                        
                        
                        12.99
                        
                        
                        
                        12.33Low
                        
                        
                        12.13
                        
                        
                        
                        12.38
                        
                        
                        
                        12.09
                        
                        
                        
                        9.72




40




ITEM
7A. Quantitative and Qualitative Disclosures About Market Risk





Information
responsive to this item in contained in Item 7. above under the captions
"Capital Adequacy and Resources", “Liquidity” and "Management of Market
Risk".




41




ITEM
8. Financial Statements and Supplementary Data











REPORT
OF INDEPENDENT REGISTERD PUBLIC ACCOUNTING FIRM





The Board
of Directors


Citizens
South Banking Corporation


Gastonia,
North Carolina





We have
audited the accompanying consolidated statements of financial condition of
Citizens South Banking Corporation and subsidiaries as of December 31, 2008 and
2007 and the related consolidated statements of income, comprehensive income,
changes in stockholders’ equity, and cash flows for each of the years in the
three-year period ended December 31, 2008.  These consolidated
financial statements are the responsibility of management. Our responsibility is
to express an opinion on these financial statements based on our
audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Citizens South Banking
Corporation and subsidiaries as of December 31, 2008 and 2007 and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2008, in conformity with accounting principles
generally accepted in the United States of America.





/s/
Cherry, Bekaert & Holland, L.L.P.





Gastonia,
North Carolina


March 16,
2009





42




CITIZENS
SOUTH BANKING CORPORATION





Consolidated
Statements of Financial Condition





December 31,2008
                
                
                2007AssetsCash
      and due from banks
                
                $
                9,443,833
                
                
                $
                14,285,431Interest-earning
      bank balances
                
                
                613,320
                
                
                
                15,454,043Cash
      and cash equivalents
                
                
                10,057,153
                
                
                
                29,739,474Investment
      securities available-for-sale
                
                
                28,904,772
                
                
                
                46,518,568Mortgage-backed
      and related securities available-for-sale
                
                
                80,275,248
                
                
                
                69,892,914Loans,
      net of deferred fees
                
                
                626,687,811
                
                
                
                559,955,975Allowance
      for loan losses
                
                
                (8,025,880
                )
                
                
                (6,144,119
                )Loans,
      net
                
                
                618,661,931
                
                
                
                553,811,856Other
      real estate owned
                
                
                2,600,708
                
                
                
                528,871Premises
      and equipment, net
                
                
                16,833,944
                
                
                
                17,964,910Accrued
      interest receivable
                
                
                2,609,100
                
                
                
                3,254,416Federal
      Home Loan Bank stock
                
                
                4,792,900
                
                
                
                4,235,700Intangible
      assets
                
                
                30,525,233
                
                
                
                31,037,233Bank
      owned life insurance
                
                
                16,812,367
                
                
                
                16,099,371Other
      assets
                
                
                5,139,339
                
                
                
                6,056,953Total
      assets
                
                $
                817,212,695
                
                
                $
                779,140,266Liabilities
      and Stockholders' EquityDeposits
                
                $
                581,487,854
                
                
                $
                590,764,822Borrowed
      money
                
                
                99,650,000
                
                
                
                70,465,000Subordinated
      debt
                
                
                15,464,000
                
                
                
                15,464,000Retail
      repurchase agreements
                
                
                9,251,093
                
                
                
                10,355,320Deferred
      compensation
                
                
                5,412,372
                
                
                
                5,388,586Other
      liabilities
                
                
                1,227,321
                
                
                
                2,669,316Total
      liabilities
                
                
                712,492,640
                
                
                
                695,107,044Commitments
      and contingenciesStockholders'
      EquityPreferred
      stock, $0.01 par value, 10,000,000 shares authorized;December
      31, 2008:  20,500 shares issued and outstanding;December
      31, 2007:  No shares issued or outstanding.
                
                
                20,506,873
                
                
                
                -Common
      stock, $0.01 par value, 20,000,000 shares authorized;December
      31, 2008:  9,062,727 shares issued and7,515,957
      shares outstanding;  December 31, 2007:9,062,727
      shares issued and 7,610,017 shares outstanding.
                
                
                90,628
                
                
                
                90,628Additional
      paid-in-capital
                
                
                67,366,826
                
                
                
                67,718,714Unallocated
      common stock held by Employee Stock Ownership Plan
                
                
                (1,064,500
                )
                
                
                (1,247,345
                )Retained
      earnings, substantially restricted
                
                
                36,088,986
                
                
                
                36,028,442Accumulated
      unrealized loss on securities available-for-sale, net of
    tax
                
                
                24,796
                
                
                
                (343,491
                )Treasury
      stock of 1,546,770 shares at December 31, 2008, and1,452,710
      shares at December 31, 2007, at cost
                
                
                (18,293,554
                )
                
                
                (18,213,726
                )Total
      stockholders' equity
                
                
                104,720,055
                
                
                
                84,033,222Total
      liabilities and stockholders' equity
                
                $
                817,212,695
                
                
                $
                779,140,266


See notes
to consolidated financial statements.


43





CITIZENS
SOUTH BANKING CORPORATION





Consolidated
Statements of Income





Year Ended
                                            
                                            
                                            Year Ended
                                            
                                            
                                            Year EndedDecember 31,
                                            
                                            
                                            December 31,
                                            
                                            
                                            December 31,2008
                                            
                                            
                                            2007
                                            
                                            
                                            2006Interest
      incomeLoans
                                            
                                            $
                                            37,228,881
                                            
                                            
                                            $
                                            40,679,196
                                            
                                            
                                            $
                                            37,447,545Interest-bearing
      bank deposits
                                            
                                            
                                            156,861
                                            
                                            
                                            
                                            446,743
                                            
                                            
                                            
                                            838,140Investment
      securities
                                            
                                            
                                            1,419,027
                                            
                                            
                                            
                                            2,669,784
                                            
                                            
                                            
                                            1,996,698Mortgage-backed
      and related securities
                                            
                                            
                                            3,802,648
                                            
                                            
                                            
                                            2,939,447
                                            
                                            
                                            
                                            2,636,696Total
      interest income
                                            
                                            
                                            42,607,417
                                            
                                            
                                            
                                            46,735,170
                                            
                                            
                                            
                                            42,919,079Interest
      expenseDeposits
                                            
                                            
                                            17,232,789
                                            
                                            
                                            
                                            22,314,968
                                            
                                            
                                            
                                            18,103,014Borrowed
      funds
                                            
                                            
                                            5,172,961
                                            
                                            
                                            
                                            4,185,148
                                            
                                            
                                            
                                            4,176,204Total
      interest expense
                                            
                                            
                                            22,405,750
                                            
                                            
                                            
                                            26,500,116
                                            
                                            
                                            
                                            22,279,218Net
      interest income
                                            
                                            
                                            20,201,667
                                            
                                            
                                            
                                            20,235,054
                                            
                                            
                                            
                                            20,639,861Provision
      for loan losses
                                            
                                            
                                            3,275,000
                                            
                                            
                                            
                                            1,290,000
                                            
                                            
                                            
                                            1,165,000Net
      interest income after provision for loan losses
                                            
                                            
                                            16,926,667
                                            
                                            
                                            
                                            18,945,054
                                            
                                            
                                            
                                            19,474,861Noninterest
      incomeFee
      income on deposit accounts
                                            
                                            
                                            3,030,900
                                            
                                            
                                            
                                            2,722,037
                                            
                                            
                                            
                                            2,855,419Fee
      income on mortgage banking activities
                                            
                                            
                                            829,238
                                            
                                            
                                            
                                            990,364
                                            
                                            
                                            
                                            638,080Fee
      income on lending activities
                                            
                                            
                                            383,939
                                            
                                            
                                            
                                            483,983
                                            
                                            
                                            
                                            644,662Net
      gain (loss) on sale of securities
                                            
                                            
                                            284,008
                                            
                                            
                                            
                                            (74,422
                                            )
                                            
                                            
                                            (41,350
                                            )Net
      gain (loss) on sale of other assets
                                            
                                            
                                            (119,857
                                            )
                                            
                                            
                                            397,588
                                            
                                            
                                            
                                            110,523Commissions
      on sales of financial products
                                            
                                            
                                            260,053
                                            
                                            
                                            
                                            289,430
                                            
                                            
                                            
                                            253,841Dividends
      on FHLB stock
                                            
                                            
                                            179,962
                                            
                                            
                                            
                                            211,560
                                            
                                            
                                            
                                            221,413Fair
      market adjustment on deferred comp. assets
                                            
                                            
                                            (128,112
                                            )
                                            
                                            
                                            121,815
                                            
                                            
                                            
                                            206,987Increase
      in value of bank owned life insurance
                                            
                                            
                                            765,977
                                            
                                            
                                            
                                            769,467
                                            
                                            
                                            
                                            762,213Life
      insurance proceeds, net
                                            
                                            
                                            -
                                            
                                            
                                            
                                            112,063
                                            
                                            
                                            
                                            -Other
      income
                                            
                                            
                                            532,972
                                            
                                            
                                            
                                            538,537
                                            
                                            
                                            
                                            489,026Total
      noninterest income
                                            
                                            
                                            6,019,080
                                            
                                            
                                            
                                            6,562,422
                                            
                                            
                                            
                                            6,140,814Noninterest
      expenseCompensation
      and benefits
                                            
                                            
                                            9,964,419
                                            
                                            
                                            
                                            9,728,565
                                            
                                            
                                            
                                            9,393,723Occupancy
                                            
                                            
                                            2,659,655
                                            
                                            
                                            
                                            2,648,284
                                            
                                            
                                            
                                            2,614,131Office
      supplies expense
                                            
                                            
                                            231,866
                                            
                                            
                                            
                                            195,016
                                            
                                            
                                            
                                            258,434Advertising
                                            
                                            
                                            401,860
                                            
                                            
                                            
                                            521,692
                                            
                                            
                                            
                                            492,133Professional
      services
                                            
                                            
                                            867,102
                                            
                                            
                                            
                                            543,881
                                            
                                            
                                            
                                            550,191Telephone
      and communications
                                            
                                            
                                            258,201
                                            
                                            
                                            
                                            258,885
                                            
                                            
                                            
                                            350,023Data
      processing
                                            
                                            
                                            460,946
                                            
                                            
                                            
                                            413,288
                                            
                                            
                                            
                                            347,043Deposit
      insurance
                                            
                                            
                                            117,313
                                            
                                            
                                            
                                            66,147
                                            
                                            
                                            
                                            65,407Amortization
      of intangible assets
                                            
                                            
                                            512,000
                                            
                                            
                                            
                                            629,000
                                            
                                            
                                            
                                            734,000Impairment
      on investment securities
                                            
                                            
                                            467,790
                                            
                                            
                                            
                                            161,910
                                            
                                            
                                            
                                            -Merger
      and restructuring expense
                                            
                                            
                                            219,515
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            56,628Other
      expense
                                            
                                            
                                            3,064,995
                                            
                                            
                                            
                                            2,728,829
                                            
                                            
                                            
                                            2,681,965Total
      noninterest expense
                                            
                                            
                                            19,225,662
                                            
                                            
                                            
                                            17,895,497
                                            
                                            
                                            
                                            17,543,678Income
      before income taxes
                                            
                                            
                                            3,720,085
                                            
                                            
                                            
                                            7,611,979
                                            
                                            
                                            
                                            8,071,997Provision
      for income taxes
                                            
                                            
                                            638,751
                                            
                                            
                                            
                                            1,947,269
                                            
                                            
                                            
                                            2,617,120Net
      income
                                            
                                            $
                                            3,081,334
                                            
                                            
                                            $
                                            5,664,710
                                            
                                            
                                            $
                                            5,454,877Earnings
      per shareBasic
      earnings per share
                                            
                                            $
                                            0.42
                                            
                                            
                                            $
                                            0.74
                                            
                                            
                                            $
                                            0.68Diluted
      earnings per share
                                            
                                            $
                                            0.42
                                            
                                            
                                            $
                                            0.73
                                            
                                            
                                            $
                                            0.67




See notes
to consolidated financial statements.
  44




CITIZENS
SOUTH BANKING CORPORATION





Consolidated
Statements of Comprehensive Income





Year Ended
                                
                                
                                Year Ended
                                
                                
                                Year EndedDecember 31,
                                
                                
                                December 31,
                                
                                
                                December 31,2008
                                
                                
                                2007
                                
                                
                                2006Net
      income
                                
                                $
                                3,081,334
                                
                                
                                $
                                5,664,710
                                
                                
                                $
                                5,454,877Items
      of other comprehensive income (loss):Items
      of other comprehensive income (loss), before taxUnrealized
      holding losses arising during period
                                
                                
                                883,337
                                
                                
                                
                                979,432
                                
                                
                                
                                919,792Reclassification
      adjustment for securities (gains)losses
      included in net income
                                
                                
                                (284,008
                                )
                                
                                
                                74,422
                                
                                
                                
                                41,350Other
      comprehensive income (loss), before tax
                                
                                
                                599,329
                                
                                
                                
                                1,053,854
                                
                                
                                
                                961,142Change
      in deferred income taxes related to changesin
      unrealized gains or losses on securitiesavailable
      for sale
                                
                                
                                (231,042
                                )
                                
                                
                                (406,261
                                )
                                
                                
                                (385,192
                                )Items
      of other comprehensive income (loss)
                                
                                
                                368,287
                                
                                
                                
                                647,593
                                
                                
                                
                                575,950Comprehensive
      income
                                
                                $
                                3,449,621
                                
                                
                                $
                                6,312,303
                                
                                
                                $
                                6,030,827




See notes
to consolidated financial statements.




45




Consolidated
Statements of Changes in Stockholders' Equity





Retained
                                                    
                                                    
                                                    AccumulatedAdditional
                                                    
                                                    
                                                    Unallocated
                                                    
                                                    
                                                    Earnings
                                                    
                                                    
                                                    Unrealized
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    TotalPreferred
                                                    
                                                    
                                                    Common
                                                    
                                                    
                                                    Paid-In
                                                    
                                                    
                                                    Common Stock
                                                    
                                                    
                                                    Substantially
                                                    
                                                    
                                                    Gains(Losses),
                                                    
                                                    
                                                    Treasury
                                                    
                                                    
                                                    Stockholders'Stock
                                                    
                                                    
                                                    Stock
                                                    
                                                    
                                                    Capital
                                                    
                                                    
                                                    Held by ESOP
                                                    
                                                    
                                                    Restricted
                                                    
                                                    
                                                    net of tax
                                                    
                                                    
                                                    Stock
                                                    
                                                    
                                                    EquityBalance,
      January 1, 2006
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    90,628
                                                    
                                                    
                                                    
                                                    67,049,158
                                                    
                                                    
                                                    
                                                    (1,613,033
                                                    )
                                                    
                                                    
                                                    30,310,653
                                                    
                                                    
                                                    
                                                    (1,567,034
                                                    )
                                                    
                                                    
                                                    (10,012,724
                                                    )
                                                    
                                                    
                                                    84,257,648Comprehensive
      results:Net
      income
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    5,454,877
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    5,454,877Other
      comprehensive results, net of tax
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    575,950
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    575,950Allocation
      from shares purchased with loan to ESOP
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    84,892
                                                    
                                                    
                                                    
                                                    182,844
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    267,736Repurchase
      of common stock
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,624,719
                                                    )
                                                    
                                                    
                                                    (2,624,719
                                                    )Vesting
      of Recognition and Retention Plan
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    279,816
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    279,816Stock
      option expense
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    25,194
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    25,194Exercise
      of options
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (322,958
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    458,751
                                                    
                                                    
                                                    
                                                    135,793Cash
      dividends declared on common stock
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,411,060
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,411,060
                                                    )Balance,
      December 31, 2006
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    90,628
                                                    
                                                    
                                                    
                                                    67,439,060
                                                    
                                                    
                                                    
                                                    (1,430,189
                                                    )
                                                    
                                                    
                                                    33,031,512
                                                    
                                                    
                                                    
                                                    (991,084
                                                    )
                                                    
                                                    
                                                    (12,178,692
                                                    )
                                                    
                                                    
                                                    85,961,235Comprehensive
      results:Net
      income
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    5,664,710
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    5,664,710Other
      comprehensive results, net of tax
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    647,593
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    647,593Allocation
      from shares purchased with loan to ESOP
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    77,844
                                                    
                                                    
                                                    
                                                    182,844
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    260,688Repurchase
      of common stock
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (6,446,335
                                                    )
                                                    
                                                    
                                                    (6,446,335
                                                    )Vesting
      of Recognition and Retention Plan (RRP)
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    302,144
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    302,144Grant
      of 10,000 shares under RRP
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (128,175
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    128,175
                                                    
                                                    
                                                    
                                                    -Stock
      giveaway (10 shares)
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (126
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    126
                                                    
                                                    
                                                    
                                                    -Stock
      option expense
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    27,967
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    27,967Exercise
      of options
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (199,009
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    283,000
                                                    
                                                    
                                                    
                                                    83,991Cash
      dividends declared on common stock
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,468,771
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,468,771
                                                    )Balance,
      December 31, 2007
                                                    
                                                    $
                                                    -
                                                    
                                                    
                                                    $
                                                    90,628
                                                    
                                                    
                                                    $
                                                    67,718,714
                                                    
                                                    
                                                    $
                                                    (1,247,345
                                                    )
                                                    
                                                    $$
                                                    36,028,442
                                                    
                                                    
                                                    $
                                                    (343,491
                                                    )
                                                    
                                                    $
                                                    (18,213,726
                                                    )
                                                    
                                                    $
                                                    84,033,222Comprehensive
      results:Net
      income
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    3,081,334
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    3,081,334Other
      comprehensive results, net of tax
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    368,287
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    368,287Issuance
      of  preferred stock and warrants
                                                    
                                                    
                                                    20,500,000
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    20,500,000Accretion
      of discount on preferred stock
                                                    
                                                    
                                                    6,873
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (6,873
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -Allocation
      from shares purchased with loan to ESOP
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (44,826
                                                    )
                                                    
                                                    
                                                    182,845
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    138,019Repurchase
      of common stock
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (1,019,441
                                                    )
                                                    
                                                    
                                                    (1,019,441
                                                    )Vesting
      of Recognition and Retention Plan (RRP)
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    342,089
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    342,089Grant
      of 90,000 shares under RRP
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (720,000
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    720,000
                                                    
                                                    
                                                    
                                                    -Stock
      option expense
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    70,849
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    70,849Exercise
      of options
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (154,653
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    219,613
                                                    
                                                    
                                                    
                                                    64,960Post
      retirement liability on split dollar arrangements
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (349,541
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (349,541
                                                    )Cash
      dividends declared on common stock
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,509,723
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (2,509,723
                                                    )Balance,
      December 31, 2008
                                                    
                                                    $
                                                    20,506,873
                                                    
                                                    
                                                    $
                                                    90,628
                                                    
                                                    
                                                    $
                                                    67,366,826
                                                    
                                                    
                                                    $
                                                    (1,064,500
                                                    )
                                                    
                                                    $$
                                                    36,088,986
                                                    
                                                    
                                                    $
                                                    24,796
                                                    
                                                    
                                                    $
                                                    (18,293,554
                                                    )
                                                    
                                                    $
                                                    104,720,055




See notes
to consolidated financial statements.
  46





CITIZENS
SOUTH BANKING CORPORATION





Consolidated
Statements of Cash Flows





Year Ended
                                          
                                          
                                          Year Ended
                                          
                                          
                                          Year EndedDecember 31,
                                          
                                          
                                          December 31,
                                          
                                          
                                          December 31,2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006Operating
      ActivitiesNet
      Income
                                          
                                          $
                                          3,081,334
                                          
                                          
                                          $
                                          5,664,710
                                          
                                          
                                          $
                                          5,454,877Adjustments
      to reconcile net income to net cashprovided by operating activitiesProvision
      for loan losses
                                          
                                          
                                          3,275,000
                                          
                                          
                                          
                                          1,290,000
                                          
                                          
                                          
                                          1,165,000Depreciation
                                          
                                          
                                          1,111,456
                                          
                                          
                                          
                                          1,159,739
                                          
                                          
                                          
                                          1,330,879Impairment
      on investment securities
                                          
                                          
                                          467,790
                                          
                                          
                                          
                                          161,910
                                          
                                          
                                          
                                          -Deferred
      income tax (benefit)
                                          
                                          
                                          (973,968
                                          )
                                          
                                          
                                          (475,628
                                          )
                                          
                                          
                                          (408,355
                                          )(Gain)
      loss on sale of investments available-for-sale
                                          
                                          
                                          (284,008
                                          )
                                          
                                          
                                          74,422
                                          
                                          
                                          
                                          41,350(Gain)
      loss on sale of other assets
                                          
                                          
                                          119,857
                                          
                                          
                                          
                                          (397,588
                                          )
                                          
                                          
                                          (110,524
                                          )Deferred
      loan origination fees
                                          
                                          
                                          109,409
                                          
                                          
                                          
                                          87,765
                                          
                                          
                                          
                                          (410,116
                                          )Amortization
      of intangible assets
                                          
                                          
                                          512,000
                                          
                                          
                                          
                                          629,000
                                          
                                          
                                          
                                          734,000Allocation
      of shares to the ESOP
                                          
                                          
                                          138,019
                                          
                                          
                                          
                                          260,688
                                          
                                          
                                          
                                          267,736Stock
      option expense
                                          
                                          
                                          70,849
                                          
                                          
                                          
                                          27,967
                                          
                                          
                                          
                                          25,194Vesting
      of shares issued for the RRP Plan
                                          
                                          
                                          342,089
                                          
                                          
                                          
                                          302,144
                                          
                                          
                                          
                                          279,816(Increase)
      decrease in interest receivable
                                          
                                          
                                          645,316
                                          
                                          
                                          
                                          (18,683
                                          )
                                          
                                          
                                          (697,037
                                          )Net
      (increase) decrease in other operating assets
                                          
                                          
                                          (3,164,150
                                          )
                                          
                                          
                                          1,183,265
                                          
                                          
                                          
                                          (1,063,582
                                          )Net
      cash provided by operating activities
                                          
                                          
                                          5,450,993
                                          
                                          
                                          
                                          9,949,711
                                          
                                          
                                          
                                          6,609,238Investing
      ActivitiesNet
      increase in loans made to customers
                                          
                                          
                                          (68,234,484
                                          )
                                          
                                          
                                          (45,748,924
                                          )
                                          
                                          
                                          (42,160,673
                                          )Proceeds
      from the sale of investment securities
                                          
                                          
                                          19,206,290
                                          
                                          
                                          
                                          8,675,120
                                          
                                          
                                          
                                          98,300Proceeds
      from the sale of mortgage-backedand
      related securities
                                          
                                          
                                          12,485,384
                                          
                                          
                                          
                                          8,299,293
                                          
                                          
                                          
                                          2,236,956Proceeds
      from the sale of loans
                                          
                                          
                                          -
                                          
                                          
                                          
                                          201,820
                                          
                                          
                                          
                                          -Proceeds
      from the sale of premises and equipment
                                          
                                          
                                          330,243
                                          
                                          
                                          
                                          800,792
                                          
                                          
                                          
                                          647,813Proceeds
      from sale of REO
                                          
                                          
                                          537,298
                                          
                                          
                                          
                                          333,788
                                          
                                          
                                          
                                          914,074Maturities
      and prepayments of investment securities
                                          
                                          
                                          2,451,661
                                          
                                          
                                          
                                          19,518,392
                                          
                                          
                                          
                                          13,848,457Maturities
      and prepayments of mortgage-backedand
      related securities
                                          
                                          
                                          14,243,713
                                          
                                          
                                          
                                          12,435,674
                                          
                                          
                                          
                                          14,967,504Purchases
      of investment securities
                                          
                                          
                                          (5,769,732
                                          )
                                          
                                          
                                          (9,829,278
                                          )
                                          
                                          
                                          (25,643,486
                                          )Purchases
      of mortgage-backed and related securities
                                          
                                          
                                          (34,970,308
                                          )
                                          
                                          
                                          (28,675,766
                                          )
                                          
                                          
                                          (6,940,190
                                          )Purchases
      (sales) of FHLB stock
                                          
                                          
                                          (557,200
                                          )
                                          
                                          
                                          (654,700
                                          )
                                          
                                          
                                          502,700Purchases
      of premises and equipment
                                          
                                          
                                          (361,856
                                          )
                                          
                                          
                                          (1,228,756
                                          )
                                          
                                          
                                          (232,149
                                          )Net
      cash used in investing activities
                                          
                                          
                                          (60,638,991
                                          )
                                          
                                          
                                          (35,872,545
                                          )
                                          
                                          
                                          (41,760,694
                                          )Financing
      ActivitiesNet
      increase in deposits
                                          
                                          
                                          (9,276,968
                                          )
                                          
                                          
                                          27,963,051
                                          
                                          
                                          
                                          45,257,970Dividends
      to stockholders
                                          
                                          
                                          (2,509,723
                                          )
                                          
                                          
                                          (2,468,771
                                          )
                                          
                                          
                                          (2,411,060
                                          )Issuance
      of preferred stock
                                          
                                          
                                          20,500,000
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Exercise
      of options
                                          
                                          
                                          64,960
                                          
                                          
                                          
                                          83,991
                                          
                                          
                                          
                                          135,793Repurchase
      of common stock
                                          
                                          
                                          (1,019,441
                                          )
                                          
                                          
                                          (6,446,335
                                          )
                                          
                                          
                                          (2,624,719
                                          )Post
      retirement liability on split dollar arrangements
                                          
                                          
                                          (349,541
                                          )
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Increase
      (decrease) in borrowed money
                                          
                                          
                                          28,080,773
                                          
                                          
                                          
                                          10,319,832
                                          
                                          
                                          
                                          (9,051,563
                                          )Increase
      in repurchase agreements
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          3,445,221Increase
      (decrease) in advances fromborrowers
      for insurance and taxes
                                          
                                          
                                          15,617
                                          
                                          
                                          
                                          (10,437
                                          )
                                          
                                          
                                          (32,647
                                          )Net
      cash provided by financing activities
                                          
                                          
                                          35,505,677
                                          
                                          
                                          
                                          29,441,331
                                          
                                          
                                          
                                          34,718,995Net
      increase (decrease) in cash and cash equivalents
                                          
                                          
                                          (19,682,321
                                          )
                                          
                                          
                                          3,518,497
                                          
                                          
                                          
                                          (432,461
                                          )Cash
      and cash equivalents at the beginning of the year
                                          
                                          
                                          29,739,474
                                          
                                          
                                          
                                          26,220,977
                                          
                                          
                                          
                                          26,653,438Cash
      and cash equivalents at the end of the year
                                          
                                          $
                                          10,057,153
                                          
                                          
                                          $
                                          29,739,474
                                          
                                          
                                          $
                                          26,220,977


See notes
to consolidated financial statements.





47





CITIZENS
SOUTH BANKING CORPORATION





Notes to
Consolidated Financial Statements





Note
1 - Organization and Summary of Significant Accounting Policies





Organization -Citizens South
Banking Corporation (also referred to as the “Company”, the “Registrant”, “We”,
“Us”, or “Our”) is a Delaware corporation that owns all of the outstanding
shares of common stock of Citizens South Bank (the “Bank”). The shares of common
stock of the Company trade on the Nasdaq Global Market under the ticker symbol
“CSBC.”  The Company’s principal business activities are overseeing
and directing the business of the Bank. The Company’s assets consist primarily
of the outstanding capital stock of the Bank, deposits held at the Bank, and
investment securities.  The Company became the holding company for the
Bank on September 30, 2002, in connection with the mutual-to-stock conversion of
Citizens South Holdings, MHC, the mutual holding company of Citizens South
Banking Corporation, a federal corporation, formerly named Gaston Federal
Bancorp, Inc., which was originally formed on March 18, 1998, for the purpose of
acting as the holding company for the Bank.


·


Citizens
South Bank, 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, commissions earned from
the sale of uninsured investment products, 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, advertising, amortization of intangible assets and other
noninterest expenses.  Results of operations are also significantly
affected by general economic and competitive conditions, changes in interest
rates, and actions of regulatory and governmental authorities. The Bank’s
wholly-owned subsidiary, Citizens South Financial Services, Inc. (doing business
as Citizens South Investment Services) acts as an independent agent selling
various uninsured financial products.  As of December 31, 2008,
Citizens South Bank had 15 full-service branch offices in the North Carolina
Counties of Gaston, Union, Rowan, and Iredell and the South Carolina County of
York.





Basis of Presentation – The accompanying consolidated
financial statements include the accounts of Citizens South Banking Corporation,
its wholly-owned subsidiary, Citizens South Bank, and the Bank’s wholly-owned
subsidiary, Citizens South Financial Services, Inc.  All significant
intercompany accounts and transactions have been eliminated.Certain of the prior
year amounts have been reclassified to conform to current year
presentation.  Such reclassifications are immaterial to the financial
statements.





Use of Estimates – The consolidated financial
statements are prepared in accordance with accounting principles generally
accepted in the United States of America which require management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes.  Actual results could differ from
those estimates.  Material estimates that are particularly susceptible
to change in the near future relate to the determination of the allowance for
loan losses and the evaluation of other-than-temporary impairment of
securities.





Cash and Cash Equivalents
– Cash and cash
equivalents include cash on hand, amounts due from banks, short-term
interest-bearing deposits, and federal funds sold.  Generally, federal
funds are purchased and sold for one-day periods.




48




Securities – Securities are classified in
one of three categories on the date of purchase as follows: 1) available for
sale, 2) held to maturity, or 3) trading.  All securities were
classified as available for sale by management at the time of
purchase.  Securities classified as available-for-sale are carried at
fair value, with unrealized gains and losses excluded from earnings and reported
as a separate component of consolidated stockholders’ equity and as an item of
other comprehensive income.  Purchases and sales of securities are
recorded on a trade-date basis.  Gains and losses are recognized on a
trade-date basis at the time of the sale using the specific identification
method.  Declines in the fair value of individual securities below
their cost that are considered “other than temporary” result in write-downs of
the individual securities to their fair value. The related write-downs are
included in the consolidated earnings of the Company. Amortization of premiums
and accretion of discounts are included in interest income over the life of the
related security, or in the case of mortgage-backed and related securities, the
estimated life of the security.
 
 Loans -Loans that management
has the intent and ability to hold for the foreseeable future are carried at
their principal balance adjusted for any deferred loan fees or expenses.
Interest income is earned on the level yield method based on the daily
outstanding balance.  Generally, loans are classified as nonaccrual,
and the accrual of interest is discontinued, when the contractual payment of
principal and interest has become 90 days past due or when, in management’s
judgment, principal or interest is not collectible in accordance with the terms
of the obligation.  Cash receipts on nonaccrual loans are applied to
principal.  The accrual of interest resumes when the loan returns to
performing status.  The Company evaluates impairment of its
residential mortgage and consumer loans on a collective
basis.  Commercial loans are considered to be impaired when, based on
current information, it is probable that the Company will not collect all
amounts due in accordance with contractual terms.  Management monitors
internally generated reports, including past due reports, payment histories,
criticized asset reports, which include loans with historical payment problems
or borrowers in troubled industries, as well as other sources of information,
such as borrower financial statements, the value of the collateral, etc., to
identify impaired loans.  Discounted cash flow analyses or the
estimated fair value of collateral are used in determining the fair value of
impaired loans.  When the ultimate collectability of the principal
balance of an impaired loan is in doubt, cash receipts are applied to
principal.  The Company did not have any loans for sale as of December
31, 2008 or 2007.
 
 Allowance
for Loan Losses - Management has established a systematic methodology for
evaluating the adequacy of the Company’s allowance for loan
losses.  The 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 under SFAS 114. 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.
 
 Concentrations of Credit Risk
– The Company makes loans
to individuals and small and medium businesses primarily in the Company’s normal
lending area which includes the North Carolina Counties of Gaston, Rowan, Union,
Mecklenburg, Cabarrus, Lincoln, Cleveland, and Iredell Counties, along with York
County, South Carolina.  The Company has a diversified loan portfolio,
and the borrowers' ability to repay their loans is not dependent upon any
specific economic segment.
 
 Other Real Estate Owned – Other real estate owned is
comprised of real estate properties acquired in partial or total satisfaction of
problem loans.  The properties are recorded at the lower of cost or
fair value less estimated costs to sell at the date acquired.  Losses
arising at the time of acquisition of such properties are charged against the
allowance for loan losses.  Subsequent write-downs that may be
required to the carrying value of these properties are charged to current
operations.  Gains and losses realized from the sale of other real
estate owned are included in current operations.
 
 49
  Premises and Equipment – Premises and equipment are
stated at cost less accumulated depreciation and
amortization.  Depreciation and amortization are computed over the
estimated useful lives of the assets (from three to 30 years) primarily by the
straight-line method.  Maintenance and repairs are charged to
operations in the period incurred.  Leasehold improvements are
amortized on a straight-line basis over the shorter of the estimated useful life
of the improvement or the lease term.  Gains and losses on
dispositions of fixed assets are included in current operations.
 
 Goodwill and Other Intangible
Assets – Statement of Financial Accounting Standards (“SFAS”)No. 142, Goodwill and Other Intangible
Assets, requires that goodwill and intangible assets with indefinite
useful lives no longer be amortized, but instead tested for impairment at least
annually in accordance with its provisions. In connection with adoption of SFAS
No. 142, the Company is required to perform an initial assessment of whether
there is an indication that goodwill is impaired. The Company completed its
annual impairment tests at December 31, 2008, 2007 and 2006 and determined based
on that analysis that goodwill was not impaired.  Goodwill is tested
for impairment annually, or between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying amount. The Company had no goodwill related to
acquisitions initiated prior to July 1, 2001, or other intangible assets
recorded prior to the adoption of the provisions of SFAS No. 142 whose carrying
amounts or amortization were changed by the adoptions of the provisions of SFAS
No. 142.  SFAS No. 142 also requires that intangible assets with
definite useful lives be amortized over their respective estimated useful lives
to their estimated residual values.  In accordance with SFAS No. 142
the Company’s core deposit intangibles, are amortized over their estimated
useful life of eight years on an accelerated basis.
 
 Income Taxes – Provisions for income taxes
are based on amounts reported in the consolidated statements of income,
excluding non-taxable income, and include changes in deferred income
taxes.  Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax
purposes.  Amounts provided for deferred income taxes relate primarily
to differences between tax and financial reporting for unrealized gains and
losses on securities available-for-sale, allowances for loan losses,
depreciation, and deferred compensation.
 
 Income and Expenses –The
Company uses the accrual method of accounting for all material income and
expense items.  Loan origination fees received and direct costs
incurred are deferred and amortized to interest income over the contractual
lives of the loans, using the level yield method.  Current period
expenses, such as advertising costs, are expensed as incurred.
 
 Stock-Based Compensation –In
December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
123(R), Share-Based
Payment.  SFAS No. 123(R) establishes standards for the
accounting for transactions in which an entity exchanges its equity instruments
for goods or services.  It also addressed transactions in which an
entity incurs liabilities in exchange for goods or services that are based on
the fair value of the entity’s equity instruments or that may be settled by the
issuance of those equity instruments.  The primary focus of this
statement is on accounting for transactions in which an entity obtains employee
services in exchange for share-based payment transactions.  This
Statement is effective for the beginning of the first interim or annual
reporting period that begins after December 15, 2005.  In October
2005, the Board of Directors vested all outstanding options that were issued
prior to December 31, 2003, to minimize the expense recognized on stock options
upon adoption of SFAS No. 123(R) in January 1, 2006.  As a result, the
expected additional compensation that would have been recognized during the year
ended December 31, 2006, was reduced from approximately $124,000 to
$25,194.   Compensation expense related to the adoption of SFAS
No. 123(R) amounted to $27,967 for the year ended December 31, 2007 and $70,849
for the year ended December 31, 2008.
 
 The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions used:  dividend yield of 3.50%, expected volatility of
35%, a risk-free interest rate of 3.5%, and expected lives of six years for the
options.
  50
  Recent Accounting Pronouncements -The following is a summary of recent authoritative pronouncements that
could have a significant impact the accounting, reporting, and/or disclosure of
financial information by the Company.
 
 Statement of Financial
Accounting Standards (“SFAS”) No. 157,“Fair
Value Measurements,”was adopted by the
Company on January 1, 2008, for financial assets and
liabilities.In accordance
with Financial Accounting Standards Board Staff Position (“FSP”) No. SFAS 157-2,“Effective
Date of FASB Statement No. 157,”the Company will delay
application of SFAS No. 157 for non-financial assets and non-financial
liabilities, until January 1, 2009.SFAS No. 157
provides a framework for measuring fair value under GAAP and enhances
disclosures about fair value measurements This Statement defines fair value as
the exchange price that would be received for an asset or paid to transfer a
liability in the most advantageous market for the asset or liability in an
orderly transaction between market participants on the measurement
date.  The Company utilizes fair value measurements to record fair
value adjustments to certain assets and to determine fair value
disclosures.  The Company has not elected the fair value option for
liabilities.  Available-for-sale securities are recorded at fair value
on a recurring basis.   Additionally, the Company may be required
to record at fair value other assets on a nonrecurring basis.  These
nonrecurring fair value adjustments typically involve the application of lower
of cost or market accounting for these other assets.  The application of SFAS
157 in situations where the market for a financial asset is not active was
clarified by the issuance of FSP No. SFAS 157-3,“Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active,”in October
2008.  FSP No. SFAS 157-3 became effective immediately and did not
significantly impact the methods by which the Corporation determines the fair
values of its financial assets.
 
 In
accordance with SFAS No. 157, when measuring fair value, the Company uses
valuation techniques that are appropriate and consistently applied.  A
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.
 
 Financial
instruments measured at fair value on a recurring basis include the
following:
 
 Securities Available for Sale -Securities available-for-sale are recorded at fair value on at least a
monthly basis.  Fair value measurement is based upon quoted prices, if
available.  If quoted prices are not available, fair values are
measured using independent pricing models or other model-based valuation
techniques such as the present value of future cash flows, adjusted for the
security’s credit rating, prepayment assumptions and other factors such as
credit loss assumptions.  Level 1 fair value is used for those
securities traded on an active exchange and U.S. Treasury securities that are
traded by broker/dealers in an active over-the-counter market and money market
funds.  As of December 31, 2008, the Company did not have any
securities that were valued using Level 1. Securities valued using Level 2
include mortgage-backed securities issued by government-sponsored enterprises
($80.3 million), municipal bonds ($25.8 million), and bonds issued by government
agencies ($503,000).  Securities valued using Level 3 include equity
securities that are not actively traded on an active exchange ($715,000),
investments in closely held subsidiaries ($464,000) and asset-backed securities
traded in less liquid markets ($1.4 million).  The fair value
measurement as of December 31, 2008, for investment securities
available-for-sale is summarized below:
 
 Fair Value Measurement UsingLevel 1
                      
                      
                      Level 2
                      
                      
                      Level 3
                      
                      
                      Total(in thousands)Securities
      available for sale
                      
                      $
                      -
                      
                      
                      $
                      106,583
                      
                      
                      $
                      2,597
                      
                      
                      $
                      109,180
 
 Certain
financial instruments are measured at fair value on a nonrecurring basis; that
is, the instruments are not measured at fair value on an ongoing basis but are
subject to fair value adjustments in certain circumstances, for example, when
there is evidence of impairment. Financial instruments measured at fair value on
a non-recurring basis include the following:
  51
  Impaired Loans– Certain
impaired loans are reported at the fair value of the underlying collateral if
repayment is expected to come from the sale of the collateral. Collateral values
are estimated using Level 2 inputs based on observable market data. During 2008,
certain impaired loans were identified and reported at fair value through a
specific valuation allowance allocation of the allowance for loan losses based
upon the fair value of the underlying collateral. As of December 31, 2008,
management identified 11 loans totaling $5.9 million that were considered to be
impaired.  All of the impaired loans were determined to have credit
losses in amounts ranging from $15,000 to $215,000.  These credit
losses amounted to $871,000 resulting in a total recorded investment of $5.0
million for these impaired loans.  Interest income recognized on these
11 loans after they were determined to be impaired was not material in
2008.   Future interest income on impaired loans will be
recognized only if the loan is not in excess of 90 days delinquent and not on
nonaccrual status.  Payments received on those loans that are on
nonaccrual status will be applied as a direct reduction of principal and no
income will be recognized until the loan has been repaid or has been placed back
on accrual status.
 
 On June
16, 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff
Position (“FSP”) EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating
Securities.”This FSP addresses whether instruments granted in
share-based payment transactions are participating securities prior to vesting
and, therefore, need to be included in the earnings allocation in computing
earnings per share under the two-class method described in paragraphs 60 and 61
of FASB Statement No. 128, “Earnings per
Share.”  EITF 03-6-1 will be effective for the Company on
January 1, 2009.  The Company is currently evaluating the impact, if
any, the adoption of EITF 03-6-1 will have on its consolidated financial
statements.
 
 In
September 2006, the Emerging Task Force (“ETF”) reached a consensus on EITF
06-4, Accounting for Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life
Insurance Arrangements. The scope of EITF 06-4 is limited to the
recognition of a liability and related compensation costs for endorsement
split-dollar life insurance policies that provide a benefit to an employee that
extends to postretirement periods. Therefore, this EITF would not apply to a
split-dollar life insurance arrangement that provides a specified benefit to an
employee that is limited to the employee’s active service period with an
employer. This EITF 06-4 is effective for fiscal years beginning after
December 15, 2007, with earlier application permitted. Upon the adoption of
EITF 06-4 on January 1, 2008, the Company recorded a liability, net of
applicable income taxes, of $350,000. This liability was recorded as a reduction
of retained earnings. Thereafter, changes in the liability will be reflected in
operating results.
 
 In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS
No. 141(R) will significantly change how entities apply the acquisition
method to business combinations. The most significant changes affecting how the
Company will account for business combinations under this Statement include: the
acquisition date will be date the acquirer obtains control; all (and only)
identifiable assets acquired, liabilities assumed, and noncontrolling interests
in the acquiree will be stated at fair value on the acquisition date; assets or
liabilities arising from noncontractual contingencies will be measured at their
acquisition date fair value only if it is more likely than not that they meet
the definition of an asset or liability on the acquisition date; adjustments
subsequently made to the provisional amounts recorded on the acquisition date
will be made retroactively during a measurement period not to exceed one year;
acquisition-related restructuring costs that do not meet the criteria in SFAS
No. 146, Accounting for
Costs Associated with Exit or Disposal Activities, will be expensed as
incurred; transaction costs will be expensed as incurred; reversals of deferred
income tax valuation allowances and income tax contingencies will be recognized
in earnings subsequent to the measurement period; and the allowance for loan
losses of an acquiree will not be permitted to be recognized by the acquirer.
Additionally, SFAS No. 141(R) will require new and modified disclosures
surrounding subsequent changes to acquisition-related contingencies, contingent
consideration, noncontrolling interests, acquisition-related transaction costs,
fair values and cash flows not expected to be collected for acquired loans, and
an enhanced goodwill rollforward. The Company will be required to
prospectively apply SFAS No. 141(R) to all business combinations completed
on or after January 1, 2009. Early adoption is not permitted. For business
combinations in which the acquisition date was before the effective date, the
provisions of SFAS No. 141(R) will apply to the subsequent accounting for
deferred income tax valuation allowances and income tax contingencies and will
require any changes in those amounts to be recorded in earnings. Management is
currently evaluating the effects that SFAS No. 141(R) will have on the
financial condition, results of operations, liquidity, and the disclosures that
will be presented in the consolidated financial statements.
 
 SFAS No.
159, “The Fair Value Option
for Financial Assets and Financial Liabilities,” including an amendment
of FASB Statement No. 115, permits entities to choose to measure eligible items
at fair value at specified election dates. Unrealized gains and losses on items
for which the fair value option has been elected are reported in earnings at
each subsequent reporting date. The fair value option (i) may be applied
instrument by instrument, with certain exceptions, (ii) is irrevocable (unless a
new election date occurs) and (iii) is applied only to entire instruments and
not to portions of instruments. SFAS No. 159 became effective for the
Corporation on January 1, 2008, and did not have a significant impact on the
Corporation’s financial statements (see Note 15 - Fair Value of Financial
Instruments).
  52
  SFAS No.
161, “Disclosures About
Derivative Instruments and Hedging Activities” amends SFAS 133, “Accounting for Derivative
Instruments and Hedging Activities,” to amend and expand the disclosure
requirements of SFAS 133 to provide greater transparency about (i) how and why
an entity uses derivative instruments, (ii) how derivative instruments and
related hedge items are accounted for under SFAS 133 and its related
interpretations, and (iii) how derivative instruments and related hedged items
affect an entity’s financial position, results of operations and cash flows. To
meet those objectives, SFAS 161 requires qualitative disclosures about
objectives and strategies for using derivatives, quantitative disclosures about
fair value amounts of gains and losses on derivative instruments and disclosures
about credit-risk-related contingent features in derivative agreements. SFAS 161
is effective for the Corporation on January 1, 2009, and is not expected to have
a significant impact on the Corporation’s financial statements.
 
 SFAS No.
162, “The Hierarchy of
Generally Accepted Accounting Principles” identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (GAAP) in
the United States (the GAAP hierarchy). The hierarchical guidance provided by
SFAS 162 did not have a significant impact on the Corporation’s financial
statements.
 
 Note
2 - Participation in U.S. Treasury Capital Purchase Program (“CPP”)
  On
December 12, 2008, Citizens South Banking Corporation entered into a Letter
Agreement (the "Purchase 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 (the "Series A
Preferred Stock"), having a liquidation amount per share equal to $1,000, for a
total price of $20,500,000 and (ii) a warrant (“the Warrant”) to purchase
428,870 shares of the Company's common stock, par value $0.01 per share (the
"Common Stock"), at an exercise price per share of $7.17.
  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. Based on the
original Purchase Agreement, the Company could not redeem the Series A Preferred
Stock during the first three years except with the proceeds from a qualified
equity offering.  After three years, the Company may, at its option,
redeem the Series A Preferred Stock at the liquidation amount plus accrued and
unpaid dividends. Subsequent to the execution of the Purchase Agreement,
legislation was passed which allowed the repayment of the Series A Preferred
Stock to be repaid at any time from non-equity sources.  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
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 will be
accounted for as components of Tier 1 capital.
  53
  The
Series A Preferred Stock and the Warrant were issued in a private placement
exempt from registration pursuant to Section 4(2) of the Securities Act of 1933,
as amended. The Company has agreed to register for resale the Series A Preferred
Stock, the Warrant and the shares of common stock underlying the Warrant (the
"Warrant Shares") if and when requested to do so in writing by the U.S.
Treasury. Neither the Series A Preferred Stock nor the Warrant will be subject
to any contractual restrictions on transfer, except that the U.S. Treasury may
only transfer or exercise an aggregate of one-half of the Warrant Shares prior
to the earlier of the date on which 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" and December 31,
2009.
 
 Note
3 - Securities
 
 The book
value and estimated fair values, as well as gross unrealized gains and losses,
of investment securities and mortgage-backed and related securities, available
for sale, as of December 31, 2008 and 2007, were as follows:
  December 31, 2008Book
                Value
              
              
              Unrealized
                Gains
              
              
              Unrealized
                Losses
              
              
              Fair
                ValueInvestment Securities:U.S.
      government agency bonds
              
              $
              500,000
              
              
              $
              2,770
              
              
              $
              -
              
              
              $
              502,770Municipal
      bonds
              
              
              26,959,201
              
              
              
              90,967
              
              
              
              (1,245,513
              )
              
              
              25,804,655Corporate
      bonds
              
              
              1,500,000
              
              
              
              -
              
              
              
              (450,000
              )
              
              
              1,050,000Trust
      preferred securities
              
              
              547,843
              
              
              
              -
              
              
              
              (179,389
              )
              
              
              368,454Other
      equity securities
              
              
              1,256,463
              
              
              
              18,600
              
              
              
              (96,170
              
              
              
              1,178,893Total
      investment securities
              
              $
              30,763,507
              
              
              $
              112,337
              
              
              $
              (1,971,072
              )
              
              $
              28,904,772
   December 31, 2008Book
                    Value
                  
                  
                  Unrealized
                    Gains
                  
                  
                  Unrealized
                    Losses
                  
                  
                  Fair
                    ValueMortgage-backed and related
      securities:Fannie
      Mae
                  
                  $
                  62,205,927
                  
                  
                  $
                  1,525,240
                  
                  
                  $
                  (117,079
                  )
                  
                  $
                  63,614,088Freddie
      Mac
                  
                  
                  13,546,669
                  
                  
                  
                  399,261
                  
                  
                  
                  (4,848
                  )
                  
                  
                  13,941,082Ginnie
      Mae
                  
                  
                  2,623,566
                  
                  
                  
                  104,807
                  
                  
                  
                  (8,295
                  )
                  
                  
                  2,720,078Total
      mortgage-backed andrelated
      securities
                  
                  $
                  78,376,162
                  
                  
                  $
                  2,029,308
                  
                  
                  $
                  (130,222
                  )
                  
                  $
                  80,275,248
 
 54


December
      31, 2007Book
                  Value
                
                
                Unrealized
                  Gains
                
                
                Unrealized
                  Losses
                
                
                Fair
                  ValueInvestment Securities:U.S.
      government agency bonds
                
                $
                11,499,539
                
                
                $
                12,662
                
                
                $
                (38,486
                )
                
                $
                11,473,715Municipal
      bonds
                
                
                31,783,351
                
                
                
                140,516
                
                
                
                (627,832
                )
                
                
                31,296,035Corporate
      bonds
                
                
                1,500,000
                
                
                
                -
                
                
                
                (46,500
                )
                
                
                1,453,500Trust
      preferred securities
                
                
                1,000,000
                
                
                
                -
                
                
                
                (14,500
                )
                
                
                985,500Other
      equity securities
                
                
                1,211,258
                
                
                
                98,560
                
                
                
                -
                
                
                
                1,309,818Total
      investment securities
                
                $
                46,994,148
                
                
                $
                251,738
                
                
                $
                (727,318
                )
                
                $
                46,518,568  December
      31, 2007Book
                  Value
                
                
                Unrealized
                  Gains
                
                
                Unrealized
                  Losses
                
                
                Fair
                  ValueMortgage-backed and related
      securities:Fannie
      Mae
                
                $
                41,927,008
                
                
                $
                114,261
                
                
                $
                (307,883
                )
                
                $
                41,733,386Freddie
      Mac
                
                
                24,922,944
                
                
                
                219,854
                
                
                
                (130,051
                )
                
                
                25,012,747Ginnie
      Mae
                
                
                3,126,360
                
                
                
                23,876
                
                
                
                (3,455
                )
                
                
                3,146,781Total
      mortgage-backed andrelated
      securities
                
                $
                69,976,312
                
                
                $
                357,991
                
                
                $
                (441,389
                )
                
                $
                69,892,914
  The book
value and estimated fair value of debt securities, available for sale at
December 31, 2008, by contractual maturity, are shown below.  Actual
maturities may differ from contractual maturities because borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties.
 
 December
      31, 2008Book
                        Value
                      
                      
                      Fair
                        ValueInvestment Securities:Due
      in one year or less
                      
                      $
                      450,028
                      
                      
                      $
                      451,125Due
      after one yearthrough five
      years
                      
                      
                      2,193,691
                      
                      
                      
                      2,222,841Due
      after five years through ten years
                      
                      
                      4,216,196
                      
                      
                      
                      3,808,360Due
      after ten years
                      
                      
                      22,647,129
                      
                      
                      
                      21,243,553Equities
                      
                      
                      1,256,463
                      
                      
                      
                      1,178,893Total
      investment securities
                      
                      $
                      30,763,507
                      
                      
                      $
                      28,904,772Mortgage-backed
      and related securities
                      
                      $
                      78,376,162
                      
                      
                      $
                      80,275,248
  55
  Gross
realized gains on the sale of securities available for sale were $410,195,
$81,524, and $92,964 for the years ended December 31, 2008, December 31, 2007,
and December 31, 2006, respectively.  Gross realized losses on the
sale of securities available for sale were $126,188, $155,946, and $134,314 for
the years ended December 31, 2008, December 31, 2007, and December 31, 2006,
respectively.  After-tax net gains (losses) on the sale of securities
were $174,523, ($45,732), and ($25,409) for the years ended December 31, 2008,
December 31, 2007, and December 31, 2006, respectively.
 
 As of
December 31, 2008, investment securities having a carrying amount of $12,737,434
have been pledged as collateral to secure public deposits, $11,987,933 have been
pledged as collateral for retail repurchase agreements, $30,207,676 have been
pledged as collateral for wholesale repurchase agreements, $325,000 have been
pledged as collateral for Federal Reserve Bank Treasury Tax and Loan deposits,
and $6,406,945 have been pledged as collateral for borrowings.
 
 Interest
earned from municipal securities, which is exempt from income taxes, for the
past three years were $1,175,136, $1,382,458, and $516,358 for the years ending
December 31, 2008, December 31, 2007, and December 31, 2006,
respectively.
 
 The
unrealized losses and fair value of the investments by investment type
segregated between those that have been in a continuous unrealized loss position
for less than twelve months and more than twelve months at December 31, 2008,
and December 31, 2007, are as follows:
 
 December
      31, 2008Less
      than 12 months
                                  
                                  
                                  12
      months or more
                                  
                                  
                                  TotalFair
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Fair
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Fair
                                  
                                  
                                  UnrealizedDescription
      of Securities
                                  
                                  Value
                                  
                                  
                                  Loss
                                  
                                  
                                  Value
                                  
                                  
                                  Loss
                                  
                                  
                                  Value
                                  
                                  
                                  LossU.S.  government
      agency bonds
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -Municipal
      bonds
                                  
                                  
                                  13,111,002
                                  
                                  
                                  
                                  (552,863
                                  )
                                  
                                  
                                  3,402,313
                                  
                                  
                                  
                                  (692,650
                                  )
                                  
                                  
                                  16,513,315
                                  
                                  
                                  
                                  (1,245,513
                                  )Corporate
      bonds
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,050,000
                                  
                                  
                                  
                                  (450,000
                                  )
                                  
                                  
                                  1,050,000
                                  
                                  
                                  
                                  (450,000
                                  )Trust
      preferred securities
                                  
                                  
                                  368,454
                                  
                                  
                                  
                                  (179,389
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  368,454
                                  
                                  
                                  
                                  (179,389
                                  )Other
      equity securities
                                  
                                  
                                  167,667
                                  
                                  
                                  
                                  (96,170
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  167,667
                                  
                                  
                                  
                                  (96,170
                                  )Mortgage-backed
      and related securities
                                  
                                  
                                  5,701,374
                                  
                                  
                                  
                                  (55,451
                                  )
                                  
                                  
                                  4,177,481
                                  
                                  
                                  
                                  (74,771
                                  )
                                  
                                  
                                  9,878,855
                                  
                                  
                                  
                                  (130,222
                                  )Total
      temporarily impaired securities
                                  
                                  $
                                  19,348,497
                                  
                                  
                                  $
                                  (883,873
                                  )
                                  
                                  $
                                  8,629,794
                                  
                                  
                                  $
                                  (1,217,421
                                  )
                                  
                                  $
                                  27,978,291
                                  
                                  
                                  $
                                  (2,101,294
                                  )
  56
 
 December
      31, 2007Less
      than 12 months
                                  
                                  
                                  12
      months or more
                                  
                                  
                                  TotalFair
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Fair
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Fair
                                  
                                  
                                  UnrealizedDescription of Securities
                                  
                                  Value
                                  
                                  
                                  Loss
                                  
                                  
                                  Value
                                  
                                  
                                  Loss
                                  
                                  
                                  Value
                                  
                                  
                                  LossU.S.
      government agency bonds
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  6,461,053
                                  
                                  
                                  $
                                  (38,486
                                  )
                                  
                                  $
                                  6,461,053
                                  
                                  
                                  $
                                  (38,486
                                  )Municipal
      bonds
                                  
                                  
                                  18,855,607
                                  
                                  
                                  
                                  (600,096
                                  )
                                  
                                  
                                  2,552,800
                                  
                                  
                                  
                                  (27,736
                                  )
                                  
                                  
                                  21,408,407
                                  
                                  
                                  
                                  (627,832
                                  )Corporate
      bonds
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,453,500
                                  
                                  
                                  
                                  (46,500
                                  )
                                  
                                  
                                  1,453,500
                                  
                                  
                                  
                                  (46,500
                                  )Trust
      preferred securities
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  985,500
                                  
                                  
                                  
                                  (14,500
                                  )
                                  
                                  
                                  985,500
                                  
                                  
                                  
                                  (14,500
                                  )Other
      equity securities
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Mortgage-backed
      and related securities
                                  
                                  
                                  2,994,589
                                  
                                  
                                  
                                  (6,932
                                  )
                                  
                                  
                                  28,737,077
                                  
                                  
                                  
                                  (434,457
                                  )
                                  
                                  
                                  31,731,666
                                  
                                  
                                  
                                  (441,389
                                  )Total
      temporarily impaired securities
                                  
                                  $
                                  21,850,196
                                  
                                  
                                  $
                                  (607,028
                                  )
                                  
                                  $
                                  40,189,930
                                  
                                  
                                  $
                                  (561,679
                                  )
                                  
                                  $
                                  62,040,126
                                  
                                  
                                  $
                                  (1,168,707
                                  )
 
 Management
considers all of the unrealized losses that have been outstanding for 12 or more
months to be temporary impairments since the unrealized losses are primarily due
to changes in interest rates and not due to the issuer’s ability to honor their
obligations.  Management has the ability and intent to hold these
securities until they are no longer considered to be impaired, which may be
maturity.
 
 Note
4 - Loans and Allowance for Loan Losses
 
 The
following is a summary of loans outstanding by category at December
31:
 
 2008
                        
                        
                        2007Real
      estate:One-to-four
      family residential
                        
                        $
                        84,777,203
                        
                        
                        $
                        78,572,380Multi-familyresidential
                        
                        
                        23,359,180
                        
                        
                        
                        19,717,641Construction
                        
                        
                        71,453,665
                        
                        
                        
                        90,948,598Nonresidential
                        
                        
                        298,255,280
                        
                        
                        
                        254,781,774Commercial
                        
                        
                        34,451,110
                        
                        
                        
                        33,582,788Consumer
                        
                        
                        114,286,742
                        
                        
                        
                        82,362,726Gross
      loans
                        
                        
                        626,583,180
                        
                        
                        
                        559,965,907Less:Deferred
      loan fees, net and other items
                        
                        
                        (104,631
                        )
                        
                        
                        9,932Allowance
      for loan losses
                        
                        
                        8,025,880
                        
                        
                        
                        6,144,119Net
      loans
                        
                        $
                        618,661,931
                        
                        
                        $
                        553,811,856
  57
  The
Company evaluates impairment of its residential mortgage and consumer loans on a
collective basis. Commercial loans individually evaluated and considered
impaired under SFAS No. 114.  At December 31, 2008, management
determined that impaired loans totaled $5.9 million.  At December 31,
2007, the total of impaired loans were immaterial.
 
 Changes
in the allowance for loan losses for the years ended December 31, 2008, December
31, 2007 and December 31, 2006 were as follows:
  2008
                
                
                2007
                
                
                2006Balance
      at beginning of year
                
                $
                6,144,119
                
                
                $
                5,763,923
                
                
                $
                5,102,304Provision
      for loan losses
                
                
                3,275,000
                
                
                
                1,290,000
                
                
                
                1,165,000Loans
      charged off
                
                
                (1,460,145
                )
                
                
                (1,253,619
                )
                
                
                (523,022
                )Recoveries
      on loans previously charged off
                
                
                66,906
                
                
                
                343,815
                
                
                
                19,641Allowances
      acquired in acquisition
                
                
                -
                
                
                
                -
                
                
                
                -Balance
      at end of year
                
                $
                8,025,880
                
                
                $
                6,144,119
                
                
                $
                5,763,923
 
 Directors,
executive officers, and associates of such persons are customers of and had
transactions with the Bank in the ordinary course of business.  As a
matter of policy, these loans and lines of credit are approved by the Board of
Directors and are made with interest rates, terms, and collateral requirements
available to the general public.  The aggregate amounts of these loans
were $8,536,105 and $8,077,988 at December 31, 2008 and 2007,
respectively.  During the year ended December 31, 2008, new loans of
$2,247,528 were made and payments totaled $1,818,638. During the year ended
December 31, 2007, new loans of $8,647,678 were made and payments totaled
$6,336,287.
 
 The Bank
held no loans for sale at December 31, 2008 and 2007.
 
 Note
5 - Premises and Equipment
 
 Premises
and equipment at December 31 are summarized as follows:
 
 2008
                          
                          
                          2007Land
                          
                          $
                          4,999,661
                          
                          
                          $
                          5,371,888Buildings
                          
                          
                          13,290,033
                          
                          
                          
                          13,437,635Leasehold
      Improvements
                          
                          
                          286,035
                          
                          
                          
                          268,728Land
      Improvements
                          
                          
                          285,195
                          
                          
                          
                          286,424Furniture
      and equipment
                          
                          
                          5,062,350
                          
                          
                          
                          4,620,676Premises
      and equipment
                          
                          
                          23,923,274
                          
                          
                          
                          23,985,351Less:
      accumulated depreciation
                          
                          
                          7,089,330
                          
                          
                          
                          6,020,441Premises
      and equipment, net
                          
                          $
                          16,833,944
                          
                          
                          $
                          17,964,910
 58
  Note
6 – Bank Owned Life Insurance
 
 The
Company owns bank-owned life insurance to fund certain employee benefit
plans.  No purchases of bank-owned life insurance were made during the
years ended December 31, 2008, and December 31, 2007.   The
bank-owned life insurance policies are recorded in other assets at their cash
surrender values of $16,812,367 and $16,099,371 at December 31, 2008 and 2007,
respectively.
 
 Note
7 – Goodwill and Other Intangible Assets
 
 The
following is a summary of goodwill and other intangible assets at December 31,
2008 and 2007 are summarized as follows:
  2008
                    
                    
                    2007Core
      deposit intangible
                    
                    $
                    4,767,000
                    
                    
                    $
                    4,767,000Less:  Accumulated
      amortization
                    
                    
                    3,883,000
                    
                    
                    
                    3,371,000Core
      deposit intangible, net
                    
                    
                    884,000
                    
                    
                    
                    1,396,000Goodwill
                    
                    
                    29,641,233
                    
                    
                    
                    29,641,233Core
      deposit intangible, net
                    
                    $
                    30,525,233
                    
                    
                    $
                    31,037,233
 
 Amortization
expense for intangible assets subject to amortization was $512,000 during the
year ended December 31, 2008, $629,000 during the year ended December 31, 2007,
and $734,000 during the year ended December 31, 2006. Estimated amortization
expense for the next five succeeding years ending December 31 are as
follows:
 
 2009
                      
                      $
                      314,0002010
                      
                      $
                      244,0002011
                      
                      $
                      176,0002012
                      
                      $
                      111,0002013
                      
                      $
                      39,000
 
 Note
8 - Deposits
 
 Deposit
balances and interest expense and average rates paid for the years ended
December 31, 2008, December 31, 2007, and December 31, 2006 are summarized as
follows:
  December
      31, 2008
                        
                        
                        December
      31, 2007Actual
                          Balance
                        
                        
                        Interest
                          Expense
                        
                        
                        Average
                          Rate
                        
                        
                        Actual
                          Balance
                        
                        
                        InterestExpense
                        
                        
                        Average
                          RateNoninterest-bearing
                        
                        $
                        44,971,297
                        
                        
                        $
                        -
                        
                        
                        
                        -
                        
                        
                        $
                        43,571,218
                        
                        
                        $
                        -
                        
                        
                        
                        -Interest-bearing
      checking
                        
                        
                        77,760,209
                        
                        
                        
                        1,019,350
                        
                        
                        
                        1.51
                        %
                        
                        
                        58,409,636
                        
                        
                        
                        917,033
                        
                        
                        
                        1.74
                        %Money
      market deposit
                        
                        
                        103,271,148
                        
                        
                        
                        2,651,913
                        
                        
                        
                        2.29
                        
                        
                        
                        129,687,365
                        
                        
                        
                        4,908,496
                        
                        
                        
                        3.89Savings
                        
                        
                        10,707,519
                        
                        
                        
                        42,092
                        
                        
                        
                        0.36
                        
                        
                        
                        12,037,608
                        
                        
                        
                        82,351
                        
                        
                        
                        0.58Certificates
      of deposit
                        
                        
                        344,777,681
                        
                        
                        
                        13,519,434
                        
                        
                        
                        3.93
                        
                        
                        
                        347,058,995
                        
                        
                        
                        16,407,088
                        
                        
                        
                        4.79Total
      deposits
                        
                        $
                        581,487,854
                        
                        
                        $
                        17,232,789
                        
                        
                        
                        2.97
                        %
                        
                        $
                        590,764,822
                        
                        
                        $
                        22,314,968
                        
                        
                        
                        3.88
                        %
 59
 
 December
      31, 2006Actual
                            Balance
                          
                          
                          Interest
                            Expense
                          
                          
                          Average
                            RateNoninterest-bearing
                          
                          $
                          37,762,084
                          
                          
                          $
                          -
                          
                          
                          
                          -Interest-bearing
      checking
                          
                          
                          52,778,385
                          
                          
                          
                          662,072
                          
                          
                          
                          1.29
                          %Money
      market deposit
                          
                          
                          117,632,286
                          
                          
                          
                          4,186,931
                          
                          
                          
                          3.82Savings
                          
                          
                          16,026,580
                          
                          
                          
                          149,807
                          
                          
                          
                          0.77Certificates
      of deposit
                          
                          
                          338,602,436
                          
                          
                          
                          13,104,204
                          
                          
                          
                          4.09Total
      deposits
                          
                          $
                          562,801,771
                          
                          
                          $
                          18,103,014
                          
                          
                          
                          3.37
                          %
 
 Contractual
maturities of certificates of deposit as of December 31, 2008 and 2007, are as
follows:
 
 2008
                          
                          
                          2007Under
      1 year
                          
                          $
                          310,320,849
                          
                          
                          $
                          319,912,8231
      to 2 years
                          
                          
                          25,449,746
                          
                          
                          
                          18,074,9322
      to 3 years
                          
                          
                          8,120,618
                          
                          
                          
                          8,050,3963
      to 4 years
                          
                          
                          593,702
                          
                          
                          
                          317,5394
      years or greater
                          
                          
                          292,766
                          
                          
                          
                          703,305Total
                          
                          $
                          344,777,681
                          
                          
                          $
                          347,058,995
 
 Certificates
of deposit in excess of $100,000 totaled $127,767,129 and $132,186,117 at
December 31, 2008 and 2007, respectively.  Interest paid on deposits
and other borrowings was $22,946,802 for the year ended December 31, 2008,
$25,924,506, for the year ended December 31, 2007, and $21,277,860 for the year
ended December 31, 2006.
 
 Directors,
executive officers, and associates of such persons are customers of and had
transactions with the Bank in the ordinary course of
business.  Included in such transactions are deposit accounts, all of
which were made under normal terms.  The aggregate amount of these
deposit accounts was $4,960,839 and $3,426,486 at December 31, 2008 and 2007,
respectively.
 
 Note
9 – Borrowed Money
 
 As of
December 31, 2008, the Company had $73.6 million in advances from the FHLB of
Atlanta that were obtained pursuant to a line of credit.  These
advances are collateralized by a lien on qualifying first mortgage loans in an
amount necessary to satisfy outstanding indebtedness plus accrued
interest.  The total amount available on the line of credit is 25% of
total assets of the Bank, or approximately $204.3 million.  The unused
portion of the line of credit available to the Company at December 31, 2008, was
approximately $130.7 million.  These advances had interest rates
ranging from 0.46% to 6.25% during 2008 and 1.24% to 6.25% during
2007.  Interest rates on certain FHLB convertible advances may be
reset on certain dates at the option of the FHLB in accordance with the terms of
the note.  The Bank has the option of repaying the outstanding advance
or converting the interest rate from a fixed rate to a floating rate at the time
the advance is called by the FHLB.  These convertible advances totaled
$25.0 million at December 31, 2008, and $37.0 million at December 31,
2007.
 
 The
Company also had $26.0 million in repurchase agreements (“repos”) from JP Morgan
Chase Bank, NA (“JP Morgan”) and Citigroup Global Markets, Inc. (“Citi”) at
December 31, 2008.  These borrowings are collateralized by various US
Government agency investment and mortgage-backed securities in an amount equal
to at least 105% of the outstanding amount of the repurchase
agreement.   The Company had $6.0 million in repos from JP Morgan
and $20.0 million from Citi.  The interest rates on these repos range
from 1.50% to 4.48%.  Three repos totaling $11.0 million have fixed
rates and fixed maturities.  The remaining four repos, totaling $15.0
million, may be called at the option of the issuer in accordance of the terms of
the agreement.
  60
  Maturities
of borrowed money at December 31 are as follows:
 
 2008
                            
                            
                            2007Borrowed
      money due:Less
      than 1 year
                            
                            $
                            17,150,000
                            
                            
                            $
                            17,965,0001
      to 2 years
                            
                            
                            15,000,000
                            
                            
                            
                            8,000,0002
      to 3 years
                            
                            
                            9,500,000
                            
                            
                            
                            8,000,0003
      to 4 years
                            
                            
                            27,000,000
                            
                            
                            
                            1,500,0004
      to 5 years
                            
                            
                            6,000,000
                            
                            
                            
                            25,000,0005
      to 10 years
                            
                            
                            23,000,000
                            
                            
                            
                            8,000,000After
      10 years
                            
                            
                            2,000,000
                            
                            
                            
                            2,000,000Total
      borrowed money
                            
                            $
                            99,650,000
                            
                            
                            $
                            70,465,000
 
 Note
10 – Subordinated Debt
 
 On
October 31, 2005, the Company consummated the merger of Trinity Bank (“Trinity”)
into Citizens South Bank.  At the time of the acquisition, Trinity had
total assets of $165.5 million, net loans
of $112.8 million, deposits of $135.6 million, borrowed money of $14.0 million
and equity of $13.3 million.Trinity was headquartered in
Monroe, North Carolina, which is approximately 50 miles east of the Company’s
headquarters.  Under the terms of the merger agreement, the Company
issued a combination of common stock and cash for the outstanding common shares
of Trinity Bank.  Trinity shareholders were given the option of
receiving 1.3931 shares of Citizens South common stock for each share of Trinity
common stock, $18.25 in cash for each share of Trinity common stock, or a
mixture of stock and cash for each Trinity share, such that 50% of the shares of
Trinity common stock would be exchanged for Citizens South common
stock.  On October 31, 2005, Trinity shareholders received merger
consideration of approximately 1,280,052 shares of common stock of the Company
(subject to payment of cash in lieu of fractional shares) and approximately
$16.8 million in cash (including cash paid in lieu of fractional shares),
resulting in a total transaction value of approximately $37.8
million.  The transaction price represented approximately 255% of
Trinity’s book value.  Additional information regarding this
transaction may be obtained by reviewing the Registration Statement that the
Company filed with the Securities and Exchange Commission on August 1, 2005, and
amended September 14, 2005.
 
 On
October 28, 2005, CSBC Statutory Trust I issued an aggregate of $15,000,000 in
trust preferred securities, liquidation amount $1,000 per security. The
Preferred Securities mature on December 15, 2035, but may be redeemed beginning
December 15, 2010, if the Company exercises its right to redeem the Debentures,
as described below. The Preferred Securities require quarterly distributions by
the Trust to the holders of the Preferred Securities, initially at a fixed rate
of 6.095% per annum through the interest payment date in December 2010, and
thereafter at a variable rate of three-month LIBOR plus 1.57% per annum, reset
quarterly. Distributions are cumulative and will accrue from the date of
original issuance but may be deferred for a period of up to twenty consecutive
quarterly interest payment periods if the Company exercises its right under the
Indenture to defer the payment of interest on the Debentures, as described
below.   In accordance with FIN No. 46(R), “Consolidation of
Variable Interest Entities”, the trust is not consolidated with the financial
statements of the Company.
 
 The
proceeds from the sale of the Preferred Securities received by the Trust,
combined with the proceeds of $464,000 received by the Trust from the issuance
of common securities (the "Common Securities") by the Trust to the Company, were
used to purchase $15,464,000 in principal amount of unsecured junior
subordinated deferrable interest debentures (the "Debentures") of the Company,
issued pursuant to the Indenture.
 
 The
issuance of the Preferred Securities and the Common Securities are provided for
in the Trust Agreement dated October 28, 2005, by and among the Trustee, the
Company, and the administrative trustees of the Trust. The administrative
trustees are the President and Chief Executive Officer, Executive Vice President
and Secretary, and Executive Vice President and Chief Financial
Officer.
  61
  The
Debentures mature on December 15, 2035, but the Company may at its option redeem
the Debentures, in whole or in part, beginning on December 15, 2010, in
accordance with the provisions of the Indenture. The Debentures bear interest at
a fixed rate equal to 6.095% per annum through the interest payment date in
December 2010, and thereafter at a variable rate, reset quarterly, of
three-month LIBOR plus 1.57% per annum. Interest is cumulative and will accrue
from the date of original issuance. However, so long as there is no event of
default, interest payments may be deferred by the Company at its option at any
time for a period of up to twenty consecutive quarterly interest payment
periods, but not beyond December 15, 2035 (each such extended interest payment
period, an "Extension Period"). No interest shall be due and payable during an
Extension Period, but each installment of interest that would otherwise have
been due and payable during such Extension Period shall bear additional interest
at an annual rate equal to the interest rate in effect for each Extension
Period. Furthermore, during any Extension Period, the Company may not declare or
pay any dividends on its capital stock, which includes its Common Stock, nor
make any payment or redeem debt securities that rank pari passu with the
Debentures.
 
 The
Debentures may be redeemed at par at the option of the Company beginning on
December 15, 2010, and may be redeemed earlier than such date following the
occurrence of a "Special Event" (as defined in the Indenture) at a price equal
to 107.5% of the principal amount together with accrued interest. The Trust will
be required to redeem a like amount of Preferred Securities if the Company
exercises its right to redeem all or a portion of the Debentures.
 
 Either
the Trustee or the holders of at least 25% of the aggregate principal amount of
the outstanding Debentures may declare the principal amount of, and all accrued
interest on, all the Debentures to be due and payable immediately, or if the
holders of the Debentures fail to make such declaration, the holders of at least
a majority in aggregate liquidation amount of the Preferred Securities
outstanding shall have a right to make such declaration, if an Event of Default
occurs. An Event of Default generally includes a default in payment of any
interest for 30 days, a default in payment upon maturity, a default in
performance, or breach of any covenant or representation, bankruptcy or
insolvency of the Company or liquidation or dissolution of the Trust. Any holder
of the Preferred Securities has the right, upon the occurrence of an Event of
Default related to payment of interest of principal, to institute suit directly
against the Company for enforcement of payment to such holder of principal of
and any premium and interest, including additional interest, on the Debentures
having a principal amount equal to the aggregate liquidation amount of the
Preferred Securities held by such holder.
  62
  Note
11 - Income Taxes
 
 The
provision for income taxes for the years ended December 31 are summarized
below:
 
 2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006Currently
      payable:Federal
                                      
                                      $
                                      1,290,840
                                      
                                      
                                      $
                                      2,008,139
                                      
                                      
                                      $
                                      2,594,290State
                                      
                                      
                                      321,879
                                      
                                      
                                      
                                      414,758
                                      
                                      
                                      
                                      431,185Total
      current
                                      
                                      
                                      1,612,719
                                      
                                      
                                      
                                      2,422,897
                                      
                                      
                                      
                                      3,025,475Deferred:Federal
                                      
                                      
                                      (788,291
                                      )
                                      
                                      
                                      (350,238
                                      )
                                      
                                      
                                      (347,236
                                      )State
                                      
                                      
                                      (185,677
                                      )
                                      
                                      
                                      (125,390
                                      )
                                      
                                      
                                      (61,119
                                      )Total
      deferred
                                      
                                      
                                      (973,968
                                      )
                                      
                                      
                                      (475,628
                                      )
                                      
                                      
                                      (408,355
                                      )Total
      income taxes
                                      
                                      $
                                      638,751
                                      
                                      
                                      $
                                      1,947,269
                                      
                                      
                                      $
                                      2,617,120
 The
reasons for the difference between consolidated income tax expense and the
amount computed by applying the statutory federal income tax rate of 34% to
income before income taxes were as follows for the years ended December
31:
  2008
                    
                    
                    2007
                    
                    
                    2006Federal
      income taxes at statutory rate
                    
                    $
                    1,264,829
                    
                    
                    $
                    2,588,073
                    
                    
                    $
                    2,744,479Effect
      of federal tax exempt interest
                    
                    
                    (444,395
                    )
                    
                    
                    (389,183
                    )
                    
                    
                    (151,624
                    )State
      income taxes, net of federal benefit
                    
                    
                    89,894
                    
                    
                    
                    190,983
                    
                    
                    
                    244,244Increase
      in cash value of life insurance
                    
                    
                    (251,270
                    )
                    
                    
                    (314,794
                    )
                    
                    
                    (237,603
                    )Other
                    
                    
                    (20,307
                    )
                    
                    
                    (127,810
                    )
                    
                    
                    17,624$
                    638,751
                    
                    
                    $
                    1,947,269
                    
                    
                    $
                    2,617,120Effective
      tax rate
                    
                    
                    17.2
                    %
                    
                    
                    25.6
                    %
                    
                    
                    32.4
                    %
 
 Income
taxes paid for the years ended December 31, 2008, 2007, and 2006 were
$1,780,412, $3,003,664 and $3,142,078, respectively.
  63
  The tax
effects of temporary differences that give rise to significant portions of
deferred tax assets and liabilities at December 31 are as follows:
 
 2008
                                  
                                  
                                  2007Deferred
      tax assetsDeferred
      compensation
                                  
                                  $
                                  1,111,465
                                  
                                  
                                  $
                                  990,616Unrealized
      loss on securities available for sale
                                  
                                  
                                  (17,936
                                  )
                                  
                                  
                                  215,485Allowance
      for loan losses
                                  
                                  
                                  3,099,772
                                  
                                  
                                  
                                  2,342,897Capital
      loss carryforward
                                  
                                  
                                  146,361
                                  
                                  
                                  
                                  282,052Other
                                  
                                  
                                  418,252
                                  
                                  
                                  
                                  167,340Gross
      deferred tax assets
                                  
                                  
                                  4,757,914
                                  
                                  
                                  
                                  3,998,390Deferred
      tax liabilitiesExcess
      carrying value of assets acquired forfinancial reporting purposes
      over tax basis
                                  
                                  
                                  1,052,904
                                  
                                  
                                  
                                  1,028,041Deferred
      loan fees
                                  
                                  
                                  39,366
                                  
                                  
                                  
                                  194,606Other
                                  
                                  
                                  4,634
                                  
                                  
                                  
                                  102,615Gross
      deferred tax liabilities
                                  
                                  
                                  1,096,904
                                  
                                  
                                  
                                  1,325,262Net
      deferred tax asset
                                  
                                  $
                                  3,661,010
                                  
                                  
                                  $
                                  2,673,128
 
 The
Company has adopted the provisions of Financial Accounting Standards Board
Interpretation No. 48 ("FIN 48").  There was no material impact from the
adoption of FIN 48.  It is the Bank's policy to recognize interest and
penalties associated with uncertain tax positions as components of income
taxes.  There were no interest or penalties accrued during the year. 
The Company’s 2006 federal tax returns were audited in 2008 with no material
impact resulting from the findings of the audit.  The Company's
federal and state income tax returns are subject to examination for
2007.
 
 FSP No.
48-1 “Definition of Settlement
in FASB Interpretation No. 48”provides guidance on how to determine
whether a tax position is effectively settled for the purpose of recognizing
previously unrecognized tax benefits.  FSP 48-1 was effective
retroactively to January 1, 2007 and did not significantly impact the
Corporation’s financial statements.
  The
Company, in accordance with SFAS No. 109, did not record a deferred tax
liability of approximately $3.1 million related to the cumulative special bad
debt deduction for savings and loan associations recognized for income tax
reporting prior to September 30, 1988, Citizens South Bank’s base
year.
 
 Management
believes that the Company will fully realize deferred tax assets based on future
taxable temporary differences, refundable income taxes from carryback years, and
current levels of operating income.
  64
  Note
12 - Commitments
 
 Commitments
to extend credit are agreements to lend as long as there is no violation of any
condition established in the contract.  Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a
fee.  Since commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash
requirements.  These commitments represent no more than normal lending
risk that the Bank commits to its borrowers and management believes that these
commitments can be funded through normal operations.
 
 Commitments
to extend credit that include both fixed and variable rates as of December 31
are as follows:
 
 2008
                      
                      
                      2007Residential
      mortgage loan commitments
                      
                      $
                      5,903,510
                      
                      
                      $
                      7,160,455Non-residential
      mortgage loan commitments
                      
                      
                      5,934,458
                      
                      
                      
                      20,987,431Commercial
      loan commitments
                      
                      
                      457,000
                      
                      
                      
                      6,559,700Consumer
      loan commitments
                      
                      
                      3,242,250
                      
                      
                      
                      6,840,137Unused
      lines of credit:Commercial
                      
                      
                      26,424,016
                      
                      
                      
                      38,120,483Consumer
                      
                      
                      78,872,072
                      
                      
                      
                      71,831,349
 
 The
Company also had various leases in place to provide office space for two
full-service offices.  The amount paid for this leased office space
totaled $455,546 for the year ended December 31, 2008, $370,410 for the year
ended December 31, 2007, and $337,897 for the year ended December 31,
2006.  Projected lease payments over the next five years are expected
to be $466,000 for 2009, $416,000 for 2010, $379,000 for 2011, $251,000 for
2012, and $261,000 for 2013.
  65
  Note
13 - Regulatory Capital Requirements
 
 The Bank
is subject to various regulatory capital requirements administered by the
federal banking agencies.  Under the capital adequacy guidelines and
the regulatory framework for prompt corrective action, the Bank must meet
specific capital guidelines that involve quantitative measures of assets,
liabilities, and certain commitments as calculated under regulatory accounting
practices.  The capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings and
other factors.  Failure to meet minimum capital requirements can
initiate certain mandatory, and possibly discretionary, actions by regulators
that, if undertaken, could have a direct material effect on the Bank’s financial
statements.
 
 The Bank
is required to maintain: tangible capital of at least 1.5% of adjusted total
assets; core capital of at least 4.0% of adjusted total assets; and total
capital of at least 8.0% of risk weighted assets.  At December 31,
2008, the Bank’s tangible capital and core capital were $81,756,000, or 10.40%
of tangible assets, and total capital was $88,946,000, or 13.07% of
risk-weighted assets.  The Company’s primary regulator, the Office of
Thrift Supervision, informed the Bank that it was in the “well-capitalized”
category as of the most recent regulatory examination, and management is not
aware of any events that have occurred since that would have changed its
classification.
  Actual
                
                
                For
      Capital
                  Adequacy
      Purposes
                
                
                To
      Be Well
                  Capitalized
      Under
                  Prompt
      Corrective
                  Action
      ProvisionsAmount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio(Dollars
      in Thousands)
                
                
                (Dollars
      in Thousands)
                
                
                (Dollars
      in Thousands)As
      of December 31, 2008:Total Risk-Based
      Capital(to Risk-Weighted
      Assets)
                
                $
                88,946
                
                
                
                13.07
                %
                
                $
                54,454
                
                
                
                8.00
                %
                
                $
                68,068
                
                
                
                10.00
                %Tier 1
      Capital(to Risk-Weighted
      Assets)
                
                
                81,756
                
                
                
                12.01
                %
                
                
                27,227
                
                
                
                4.00
                %
                
                
                40,841
                
                
                
                6.00
                %Tier 1
      Capital(to Adjusted Total
      Assets)
                
                
                81,756
                
                
                
                10.40
                %
                
                
                31,450
                
                
                
                4.00
                %
                
                
                39,312
                
                
                
                5.00
                %Tangible
      Capital(to Adjusted Total
      Assets)
                
                
                81,756
                
                
                
                10.40
                %
                
                
                11,794
                
                
                
                1.50
                %
                
                
                23,587
                
                
                
                3.00
                %As
      of December 31, 2007:Total Risk-Based
      Capital(to Risk-Weighted
      Assets)
                
                $
                71,420
                
                
                
                11.21
                %
                
                $
                50,953
                
                
                
                8.00
                %
                
                $
                63,691
                
                
                
                10.00
                %Tier 1
      Capital(to Risk-Weighted
      Assets)
                
                
                65,276
                
                
                
                10.25
                %
                
                
                25,477
                
                
                
                4.00
                %
                
                
                38,215
                
                
                
                6.00
                %Tier 1
      Capital(to Adjusted Total
      Assets)
                
                
                65,276
                
                
                
                8.74
                %
                
                
                29,890
                
                
                
                4.00
                %
                
                
                37,362
                
                
                
                5.00
                %Tangible
      Capital(to Adjusted Total
      Assets)
                
                
                65,276
                
                
                
                8.74
                %
                
                
                11,209
                
                
                
                1.50
                %
                
                
                22,417
                
                
                
                3.00
                %
  On May
23, 2002, Citizens South Holdings, MHC approved a Plan of Conversion and
Reorganization.  As a result of the conversion, the Bank established a
memo liquidation account in an amount equal to its equity at the time of the
Conversion of approximately $44 million for the benefit of eligible account
holders and supplemental eligible account holders who continue to maintain their
accounts at the Bank after the conversion.  In the event of a complete
liquidation of the Bank, each eligible account holder and supplemental eligible
account holder will be entitled to receive a distribution from the liquidation
account in an amount proportionate to the current adjusted qualifying balances
for accounts then held.  As a result, retained earnings are
substantially restricted at December 31, 2008 and 2007.
  66
  Note
14 - Employee Benefit Plans
 
 The Bank
provides supplemental benefits to substantially all employees through a 401(k)
savings plan. Eligible participants may contribute up to 75% of eligible
compensation, with the Bank providing matching contributions of 50% of employee
contributions up to 6% of eligible compensation.  Total expense
relating to the employer match on the 401(k) was $193,139 for the year ended
December 31, 2008, $171,926 for the year ended December 31, 2007, and $165,524
for the year ended December 31, 2006.  The Board of Directors
suspended any employer match for the 401(k) savings plan effective March 1,
2009.  Reinstatement of the employer match will be evaluated on an
on-going basis.
 
 The Bank
maintains nonqualified deferred compensation and/or supplemental retirement
plans for certain of its directors and executive officers. Total expense for the
all of these plans was $398,165 for the year ended December 31, 2008, $463,860
for the year ended December 31, 2007, and $423,290 for the year ended December
31, 2006.
 
 The
Bank also adopted nonqualified deferred compensation plans for key employees and
directors of Citizens Bank, a wholly-owned subsidiary of Innes Street Financial
Corporation, which was acquired by the Company on December 31,
2001.  The deferred assets related to these plans are maintained in
rabbi trusts, which are included in Other Assets of the Company.  The
assets are accounted for at market value in accordance with SFAS No. 115, Accounting for Certain Investments
in Debt and Equity Securities, with the resulting gains or losses in
value recorded in income.  The corresponding change in fair value of
the deferred compensation obligation is recorded as compensation
expense.  As a result, there is no impact on net income as a result of
this benefit.
 
 2003
Recognition and Retention Plan (“2003 RRP”) – Pursuant to resolutions of the
Board of Directors of Citizens South Banking Corporation adopted on August 18,
2003, and the subsequent approval by the stockholders of the Company on October
23, 2003, the Company adopted and implemented the Citizens South Banking
Corporation 2003 Recognition and Retention Plan with a total of 210,398
shares.  On November 3, 2003, awards of 196,560 shares of restricted
stock were made under the 2003 RRP.  All of these shares vest over a
seven-year period commencing on the date of the award, at the rate of 30% on
November 3, 2003, 10% on January 2, 2004, 10% on November 3, 2005, and 10% per
year on November 3 of each year thereafter.  The fair market value of
the restricted stock at the time of the grant was $15.04 per
share.  During 2008, 17,405 shares vested, 3,000 shares were forfeited
and 3,500 shares were granted to employees that will vest over a five-year
period, commencing on June 16, 2008, the date of the award, at the rate of 10%
on June 16, 2009, 10% on June 16, 2010, 10% on June 16, 2011, 35% on June 16,
2012, and 35% on June 16, 2013.  In addition, 10,000 shares were
granted during 2007 with 5-year cliff vesting.  At December 31, 2008,
4,538 restricted shares remained unissued and available for grants under the
2003 RRP.  Total expense for the 2003 RRP amounted to $342,089 in
2008, $302,144 in 2007 and $279,816 in 2006.
 
 1999
Stock Option Plan -On
April 12, 1999, the Company’s stockholders approved the Citizens South Bank 1999
Stock Option Plan that provided the issuance of 211,335 options for directors
and officers to purchase the Company’s common stock.  Pursuant to the
mutual holding company conversion and reorganization completed on September 30,
2002, each share of the $1.00 par value common stock of Citizens South Banking
Corporation (the former Federal corporation) was exchanged for 2.1408 shares of
$0.01 par value common stock of the Citizens South Banking Corporation (the new
Delaware Corporation), which preserved the previous stockholders’ interest in
Citizens South Banking Corporation.  Thus, the options for 211,335
shares of common stock in the 1999 Stock Option Plan were exchanged for options
for 452,425 shares, with the exercise prices of previously granted options
adjusted according to the same ratio. During 2008, there were there were no
options granted, 11,768 shares were exercised, and no shares were forfeited
under the 1999 Stock Option Plan. All of the 11,768 shares exercised were
exercised for cash.  At December 31, 2008, 1,612 options remained
unissued and available for grants under the 1999 Stock Option
Plan.
  67
  2003
Stock Option Plan – Pursuant to resolutions of the Board of Directors of
Citizens South Banking Corporation adopted on August 18, 2003, and the
subsequent approval by the stockholders of the Company on October 23, 2003, the
Company adopted and implemented the Citizens South Banking Corporation 2003
Stock Option Plan with a total of 525,995 options available for
award.  On November 3, 2003, the following awards of stock options
were made under the 2003 Stock Option Plan: Non-statutory options of 157,020
shares at $15.04 to directors and advisory board members, vesting over a
five-year period at 20% per year, commencing on the initial date of the
optionee’s board service to the Bank or its predecessor, Gaston Federal Bank
(excluding service to the former Citizens Bank, Inc.);  incentive
options of 360,000 shares at $15.04 to employees, vesting over a five-year
period at 20% per year, commencing on the initial date of the optionee’s
employment with the Bank or its predecessor, Gaston Federal Bank (excluding
service to the former Citizens Bank, Inc.).  During 2008, there were
5,000 incentive options granted at the market price of the stock on the date of
grant to an employee, vesting over a five-year period at 20% per year,
commencing on the date of the grant, no reload options were issued, no options
were exercised, and 20,000 options were forfeited. At December 31, 2008, 24,475
options remained unissued and available for grants under the 2003 Stock Option
Plan.
 
 2008
Equity Incentive Plan – Pursuant to resolutions of the Board of Directors of
Citizens South Banking Corporation adopted on April 21, 2008, and the subsequent
approval by the stockholders of the Company on May 12, 2008, the Company adopted
and implemented the Citizens South Banking Corporation 2008 Equity Incentive
Plan with a total of 300,000 shares of common stock available for award pursuant
to grants of incentive stock options, non-statutory stock options, and
restricted stock awards.  No more than 100,000 shares may be issued as
restricted stock awards.  All shares may be issued as incentive stock
options.  On June 16, 2008, the following awards were made under the
2008 Equity Incentive Plan:  Non-statutory stock options of 20,000
shares at $8.00 to Company directors and subsidiary bank board members, vesting
over a five-year period at 20% per year, commencing on the date of grant, with
the first installment vesting one year from the date of grant, or on June 16,
2009, and continuing each anniversary thereafter through June 16, 2013;
incentive stock options of 146,000 shares at $8.00 to employees, vesting over a
five-year period at 20% per year, commencing on the initial date of the grant,
with the first installment vesting one year from the date of grant, or on June
16, 2009, and continuing each anniversary thereafter through June 16, 2013;
restricted stock awards of 9,000 shares to Company directors that will vest over
a five-year period, commencing on June 16, 2008, the date of the award, at the
rate of 10% on June 16, 2009, 10% on June 16, 2010, 10% on June 16, 2011, 35% on
June 16, 2012, and 35% on June 16, 2013; and restricted stock awards of 81,000
shares to employees that will vest over a five-year period, commencing on June
16, 2008, the date of the award, at the rate of 10% on June 16, 2009, 10% on
June 16, 2010, 10% on June 16, 2011, 35% on June 16, 2012, and 35% on June 16,
2013.  Also during 2008, there were an additional 6,000 incentive
stock options granted under the 2008 Equity Incentive Plan to employees at the
market price of the stock on the date of the grants, vesting over a five-year
period at 20% per year, commencing on the date of the grant; no options were
exercised, no options were forfeited; no restricted stock vested; and no
restricted stock was forfeited.  At December 31, 2008, 38,000 shares
remained unissued and available for grants under the 2008 Equity Incentive Plan,
of which 10,000 shares may be issued as restricted stock awards and 28,000
shares may be issued as stock options.
  68
  The
following is a summary of stock option activity and related information for the
years ended December 31, 2008, 2007 and 2006.
 
 2008
                                                        
                                                        
                                                        2007
                                                        
                                                        
                                                        2006Weighted
      Avg.
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Weighted
      Avg.
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Weighted
      Avg.Options
                                                        
                                                        
                                                        Exercise
      Price
                                                        
                                                        
                                                        Options
                                                        
                                                        
                                                        Exercise
      Price
                                                        
                                                        
                                                        Options
                                                        
                                                        
                                                        Exercise
      PriceOutstanding-Beginning
      of period
                                                        
                                                        
                                                        732,886
                                                        
                                                        
                                                        $
                                                        13.09
                                                        
                                                        
                                                        
                                                        740,871
                                                        
                                                        
                                                        $
                                                        12.95
                                                        
                                                        
                                                        
                                                        772,680
                                                        
                                                        
                                                        $
                                                        12.22Granted
                                                        
                                                        
                                                        177,000
                                                        
                                                        
                                                        
                                                        7.98
                                                        
                                                        
                                                        
                                                        8,000
                                                        
                                                        
                                                        
                                                        12.47
                                                        
                                                        
                                                        
                                                        5,894
                                                        
                                                        
                                                        
                                                        12.70Exercised
                                                        
                                                        
                                                        (11,768
                                                        )
                                                        
                                                        
                                                        5.52
                                                        
                                                        
                                                        
                                                        (14,985
                                                        )
                                                        
                                                        
                                                        5.61
                                                        
                                                        
                                                        
                                                        (26,203
                                                        )
                                                        
                                                        
                                                        5.61Forfeited
                                                        
                                                        
                                                        (20,000
                                                        )
                                                        
                                                        
                                                        15.04
                                                        
                                                        
                                                        
                                                        (1,000
                                                        )
                                                        
                                                        
                                                        12.72
                                                        
                                                        
                                                        
                                                        (11,500
                                                        )
                                                        
                                                        
                                                        14.68Outstanding-end
      of period
                                                        
                                                        
                                                        878,118
                                                        
                                                        
                                                        $
                                                        12.12
                                                        
                                                        
                                                        
                                                        732,886
                                                        
                                                        
                                                        $
                                                        13.09
                                                        
                                                        
                                                        
                                                        740,871
                                                        
                                                        
                                                        $
                                                        12.95Exercisable-end
      of period
                                                        
                                                        
                                                        684,618
                                                        
                                                        
                                                        $
                                                        13.18
                                                        
                                                        
                                                        
                                                        709,586
                                                        
                                                        
                                                        $
                                                        13.11
                                                        
                                                        
                                                        
                                                        718,971
                                                        
                                                        
                                                        $
                                                        12.96Weighted
      average fair value of options grantedduring
      the period
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        2.14
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        4.27
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        4.35
 
 Exercise
prices for options outstanding as of December 31, 2008 and 2007, ranged from
$5.605 to $15.06.  The weighted average remaining contractual life of
those options was approximately five years at December 31, 2008, and four years
at December 31, 2007.
 
 Employee
Stock Ownership Plan - The Bank established an Employee Stock Ownership Plan
(ESOP) in 1998.  The ESOP is a tax-qualified retirement plan designed
to invest primarily in the Company’s common stock.  All full-time
employees of the Bank who have completed one year of service with the Bank are
eligible to participate in the ESOP.  The ESOP utilized funds borrowed
from the Company totaling $1,690,680, to purchase approximately 8%, or 169,068
shares of the Company’s common stock issued in the 1998
Conversion.  The ESOP utilized funds borrowed from the Company
totaling $1,051,980 to purchase 105,198 additional shares of the Company’s
common stock issued in the 2002 Conversion.  The loans to the ESOP
will be primarily repaid with contributions from the Bank to the ESOP over a
period not to exceed 15 years for each loan.  Under the terms of the
ESOP, the Bank makes contributions to the ESOP sufficient to cover all payments
of principal and interest as they become due.  The 1998 loan had an
outstanding balance of $450,847 with an interest rate of 3.25% and $563,559 with
an interest rate of 7.25% at December 31, 2008 and 2007,
respectively.  The interest rate on the loan is based on the Bank’s
prime rate at the end of each calendar year. The 2002 loan had an outstanding
balance of $561,056 with an interest rate of 3.25% and $631,188 with an interest
rate of 7.25% at December 31, 2008 and 2007,
respectively.  Unallocated shares, totaling 123,302 shares at December
31, 2008, are excluded for the calculation of earnings per share.
 
 Shares
purchased with the loan proceeds are held in a suspense account by the trustee
of the plan for future allocation among participants as the loan is
repaid.  Contributions to the ESOP and shares released from the
suspense account are allocated among participants on the basis of compensation
as described in the plan.  The number of shares released to
participants will be determined based upon the percentage of principal and
interest payments made during the year divided by the total remaining principal
and interest payments including the current year’s
payment.  Participants will vest in the shares allocated to their
respective accounts over a period not to exceed three years.  Any
forfeited shares are allocated to the then-remaining participants in the same
proportion as contributions.  As of December 31, 2008, 292,245 shares
have been allocated to participants and 123,302 shares remain
unallocated.  The fair value of the unallocated shares was $738,579 at
December 31, 2008.  The Company recognizes compensation expense
attributable to the ESOP ratably over the fiscal year based upon the estimated
number of ESOP shares to be allocated each December 31st.  The Company
recognized $96,882, $204,442, and $215,287 as compensation expense in the years
ended December 31, 2008, December 31, 2007, and December 31, 2006,
respectively.
  69
  The
trustee for the ESOP must vote all allocated shares held in the ESOP trust in
accordance with the instructions of the participants.  Unallocated
shares held by the ESOP trust are voted by the trustee in a manner calculated to
most accurately reflect the results of the allocated ESOP shares voted, subject
to the requirements of the Employee Retirement Income Security Act of 1974, as
amended (ERISA).
 
 Note
15 - Fair Value of Financial Instruments
 
 The
following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments.  In cases where
quoted market prices are not available, fair values are based on estimates using
present value or other valuation techniques.  The estimates are
significantly affected by the assumptions used, including discount rates and
estimates of future cash flows.  These estimates may differ
substantially from amounts that could be realized in an immediate sale or
settlement of the instrument.
 
 Fair
value approximates book value for the following financial instruments due to
their short-term nature: cash and due from banks, interest-earning bank
balances, and advances from customers for taxes and insurance.
 
 Fair
value for investment securities and mortgage-backed and related securities are
based on quoted market prices.  If a quoted market price is not
available, fair value is estimated using market prices for similar
securities.
 
 Fair
value for variable rate loans that reprice frequently is based on the carrying
value reduced by an estimate of credit losses inherent in the
portfolio.  Fair value for all other loans is estimated by discounting
their future cash flows using interest rates currently being offered for loans
of comparable terms and credit quality.
 
 Fair
value for demand deposit accounts and interest-bearing accounts with no fixed
maturity is equal to the carrying value.  Certificate of deposit fair
values are estimated by discounting cash flows from expected maturities using
interest rates currently being offered for similar instruments.
 
 Fair
value for repurchase agreements and other borrowed money is based on discounted
cash flows using current interest rates.
 
 At
December 31, 2008 and 2007, 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 December 31, 2008 and 2007, the carrying amounts and
fair values of these off-balance sheet financial instruments were
immaterial.
  70
  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 as of December 31 were as follows:
  2008
                
                
                2007Carrying
                  Amount
                
                
                Estimated
                  Fair
      Value
                
                
                Carrying
                  Amount
                
                
                Estimated
                  Fair
      ValueFinancial
      assets:Cash
      and due from banks
                
                $
                9,446,833
                
                
                $
                9,446,833
                
                
                $
                14,285,431
                
                
                $
                14,285,431Interest-earning
      bank balances
                
                
                613,320
                
                
                
                613,320
                
                
                
                15,454,043
                
                
                
                15,454,043Investments
      and mortgage-backed
      securities
                
                
                109,180,020
                
                
                
                108,750,606
                
                
                
                116,411,482
                
                
                
                113,367,543Loans
                
                
                626,678,811
                
                
                
                639,504,997
                
                
                
                559,955,975
                
                
                
                557,407,196Financial
      liabilities:Deposits
                
                
                581,487,854
                
                
                
                577,8763,493
                
                
                
                590,764,822
                
                
                
                580,344,322Repurchase
      agreements
                
                
                9,251,093
                
                
                
                9,263,419
                
                
                
                10,355,320
                
                
                
                10,355,320Borrowed
      money
                
                
                115,114,000
                
                
                
                118,873,319
                
                
                
                85,929,000
                
                
                
                87,379,471
  71
  Note
16 - Earnings per share
 
 Earnings
per share has been determined under the provisions of SFAS No. 128, Earnings Per
Share.  Basic earnings per share is computed by dividing net
income applicable to common stock by the weighted average number of common
shares outstanding during the period, without considering any dilutive
items.  Diluted earnings per share is computed by dividing net income
applicable to common stock by the weighted average number of common shares and
common stock equivalents for items that are dilutive, net of shares assumed to
be repurchased using the treasury stock method.  Common stock
equivalents arise from the assumed conversion of outstanding stock
options.
 
 The only
potential stock of the Company as defined in SFAS No. 128, are stock options
granted to various directors and officers of the Bank and unvested RRP
shares.  At December 31, 2008, the Company excluded 780,697 of the
878,118 outstanding options from the calculation of diluted earnings per share
since these options had a strike price in excess of the market value of the
stock at December 31, 2008. The following is a summary of the computation of
basic and diluted earnings per share for the years ended December
31:
 
 2008
                      
                      
                      2007
                      
                      
                      2006Net
      income
                      
                      $
                      3,081,334
                      
                      
                      $
                      5,664,710
                      
                      
                      $
                      5,454,877Weighted
      average outstanding shares
                      
                      
                      7,374,051
                      
                      
                      
                      7,688,022
                      
                      
                      
                      8,017,956Basic
      earnings per share
                      
                      $
                      0.42
                      
                      
                      $
                      0.74
                      
                      
                      $
                      0.68Weighted
      average outstanding shares
                      
                      
                      7,374,051
                      
                      
                      
                      7,688,022
                      
                      
                      
                      8,017,956Dilutive
      effect of stock options
                      
                      
                      18,422
                      
                      
                      
                      65,917
                      
                      
                      
                      77,320Weighted
      average diluted shares
                      
                      
                      7,392,472
                      
                      
                      
                      7,753,940
                      
                      
                      
                      8,095,276Diluted
      earnings per share
                      
                      $
                      0.42
                      
                      
                      $
                      0.73
                      
                      
                      $
                      0.67
 
 The
Company had 9,062,727 shares of common stock issued and outstanding as of
September 30, 2002.  Since that time, the Company’s Board of Directors
has authorized eight stock repurchase plans.  As a result, the Company
has repurchased a total of 3,213,911 shares, or 35.5% of the original
outstanding shares, at an average price of $13.06 per
share.
  72
  Note
17 - Parent-Only Financial Information
 
 The
earnings of the Bank are recognized by Citizens South Banking Corporation using
the equity method of accounting.  Accordingly, undistributed earnings
of the Bank are recorded as increases in the Company’s investment in the
Bank.  The following are the condensed financial statements of the
Company as of December 31, 2008 and 2007, and for the years ended December 31,
2008, 2007 and 2006.
 
 Condensed Statements of
Financial Condition
  2008
                    
                    
                    2007AssetsCash
      and cash equivalents
                    
                    $
                    6,040,667
                    
                    
                    $
                    995,258Investment
      in securities available-for-sale
                    
                    
                    1,470,716
                    
                    
                    
                    1,978,950Investment
      in subsidiary
                    
                    
                    112,720,115
                    
                    
                    
                    96,412,730Other
      assets
                    
                    
                    271,806
                    
                    
                    
                    166,066Total
      assets
                    
                    $
                    120,503,304
                    
                    
                    $
                    99,553,004Liabilities and Stockholders'
      EquityLiabilities
                    
                    $
                    15,783,249
                    
                    
                    $
                    15,519,783Stockholders'
      equity
                    
                    
                    104,720,055
                    
                    
                    
                    84,033,221Total
      liabilities and stockholders' equity
                    
                    $
                    120,503,304
                    
                    
                    $
                    99,553,004
 
 Condensed Statements of
Operations
 
 2008
                          
                          
                          2007
                          
                          
                          2006Interest
      income
                          
                          $
                          143,197
                          
                          
                          $
                          170,784
                          
                          
                          $
                          151,708Interest
      expense
                          
                          
                          (1,002,752
                          )
                          
                          
                          (942,530
                          )
                          
                          
                          (942,530
                          )Other
      noninterest income
                          
                          
                          997
                          
                          
                          
                          2,273
                          
                          
                          
                          92,964Other
      noninterest expenses
                          
                          
                          (1,017,717
                          )
                          
                          
                          (1,058,972
                          )
                          
                          
                          (755,776
                          )Loss
      before income taxes and undistributed earnings from
      subsidiaries
                          
                          
                          (1,876,275
                          )
                          
                          
                          (1,828,445
                          )
                          
                          
                          (1,453,634
                          )Income
      taxes
                          
                          
                          703,000
                          
                          
                          
                          703,000
                          
                          
                          
                          563,000Loss
      before undistributed earnings from subsidiaries
                          
                          
                          (1,173,275
                          )
                          
                          
                          (1,125,445
                          )
                          
                          
                          (890,634
                          )Equity
      in undistributed earnings of subsidiaries
                          
                          
                          4,254,609
                          
                          
                          
                          6,790,155
                          
                          
                          
                          6,345,511Net
      income
                          
                          $
                          3,081,334
                          
                          
                          $
                          5,664,710
                          
                          
                          $
                          5,454,877
  73
  Condensed Statements of Cash
Flows
 
 2008
                            
                            
                            2007
                            
                            
                            2006Operating
      activitiesNet
      income
                            
                            $
                            3,081,334
                            
                            
                            $
                            5,664,710
                            
                            
                            $
                            5,454,877Adjustments
      to reconcile net income to netCash
      provided by (used in) operating activities:Gain
      on sale of investments
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (92,964
                            )Impairment
      of investment securities
                            
                            
                            -
                            
                            
                            
                            161,910
                            
                            
                            
                            -Equity
      in undistributed earnings ofSubsidiaries
                            
                            
                            (4,254,609
                            )
                            
                            
                            (6,790,155
                            )
                            
                            
                            (6,345,511
                            )Allocation
      of shares to ESOP
                            
                            
                            138,019
                            
                            
                            
                            260,688
                            
                            
                            
                            267,736Stock
      option expense
                            
                            
                            70,849
                            
                            
                            
                            27,967
                            
                            
                            
                            25,194Vesting
      of shares issued for the RRP
                            
                            
                            342,089
                            
                            
                            
                            302,144
                            
                            
                            
                            279,816(Decrease)
      increase in other operating liabilities
                            
                            
                            381,931
                            
                            
                            
                            494,901
                            
                            
                            
                            (7,234
                            )Net
      cash provided by (used in) operating activities
                            
                            
                            (240,387
                            )
                            
                            
                            122,165
                            
                            
                            
                            (418,086
                            )Investing
      activitiesProceeds
      from the sale of investments
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            191,014Net
      cash provided by investing activities
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            191,014Financing
      activitiesIssuance
      of preferred stock
                            
                            
                            20,500,000
                            
                            
                            
                            -
                            
                            
                            
                            -Repurchase
      of common stock
                            
                            
                            (1,019,441
                            )
                            
                            
                            (6,446,335
                            )
                            
                            
                            (2,624,719
                            )Contributed
      capital to bank subsidiary
                            
                            
                            (15,000,000
                            )
                            
                            
                            -
                            
                            
                            
                            -Dividends
      received from bank subsidiary
                            
                            
                            3,250,000
                            
                            
                            
                            7,500,000
                            
                            
                            
                            6,000,000Exercise
      of options
                            
                            
                            64,960
                            
                            
                            
                            83,991
                            
                            
                            
                            135,793Dividends
      to stockholders
                            
                            
                            (2,509,723
                            )
                            
                            
                            (2,468,771
                            )
                            
                            
                            (2,411,060
                            )Net
      cash provided by (used in) financing activities
                            
                            
                            5,285,796
                            
                            
                            
                            (1,331,115
                            )
                            
                            
                            1,100,014Net
      increase (decrease) in cash and cash equivalents
                            
                            
                            5,045,409
                            
                            
                            
                            (1,208,950
                            )
                            
                            
                            872,942Cash
      and cash equivalents, beginning of year
                            
                            
                            995,258
                            
                            
                            
                            2,204,208
                            
                            
                            
                            1,331,266Cash
      and cash equivalents, end of year
                            
                            $
                            6,040,667
                            
                            
                            $
                            995,258
                            
                            
                            $
                            2,204,208
  74
  ITEM
9.           Changes in
and Disagreements with Accountants on Accounting and Financial
Disclosure
 
 None.
 
 ITEM
9A.        Controls and
Procedures
 
 Under the
supervision and with the participation of the Company’s management, including
the Company’s Principal Executive Officer and Principal Financial Officer, the
Company has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
under the Exchange Act) as of the end of the period covered by this
report.  Based upon that evaluation, the Principal Executive Officer
and Principal Financial Officer concluded that, as of the end of the period
covered by this report, the Company’s disclosure controls and procedures were
effective to ensure 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.
 
 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.
 
 Management’s
Annual Report on Internal Control over Financial Reporting
 
 Management
of Citizens South Banking Corporation (the “Company”) is responsible for
establishing and maintaining adequate internal control over financial reporting
as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of
1934, as amended. The Company’s internal control over financial reporting is
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles.  There were
no material changes to the Company’s internal control over financial reporting
during the year.
 
 The
Company’s internal control over financial reporting includes those policies and
procedures that:
 
 ·
                pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of the assets of the
      Company;
 ·
                provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that material receipts and expenditures of the
      Company are being made only in accordance with the authorizations of
      management and directors of the Company;
and
 ·
                provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use, or disposition of the Company’s assets that
      could have a material effect on the financial statements of the
      Company.
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate. Management
assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2008. In making this assessment, management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal Control-Integrated
Framework.
 
 Based on
our assessment and those criteria, management believes that the Company
maintained effective internal control over financial reporting as of December
31, 2008.
  75
  ITEM
9B.         Other
Information
 
 None.
 
 PART III
 
 ITEM
10.         Directors, Executive
Officers and Corporate Governance
 
 The “Proposal I – Election of
Directors” section of the Registrant’s Definitive Proxy Statement (the “Proxy
Statement”) to be filed pursuant to Section 14 of the Securities Exchange Act of
1934 in connection with the 2008 Annual Meeting of Shareholders is incorporated
herein by reference.  In addition, the Item 1. “Executive Officers of
the Registrant” section of the Proxy Statement is incorporated herein by
reference.
 
 ITEM
11.         Executive
Compensation
 
 The “Proposal I – Election of
Directors” section of the Registrant’s Proxy Statement is incorporated herein by
reference.
 
 ITEM
12.         Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder
Matters
 
 The “Proposal I – Election of
Directors” section of the Registrant’s Proxy Statement is incorporated herein by
reference.
 
 ITEM
13.         Certain Relationships,
Related Transactions and Director Independence
 
 The “Proposal I – Election of
Directors” section of the Registrant’s Proxy Statement is incorporated herein by
reference.
 
 ITEM
14.         Principal Accountant
Fees and Services
 
 The “Proposal I – Election of
Directors” section of the Registrant’s Proxy Statement is incorporated herein by
reference.
 
 PART IV
 
 ITEM
15.         Exhibits and Financial
Statement Schedules
 
 (a)(1)
                      
                      Financial StatementsThe
      following documents are filed as item 8 of this Form
  10-K.(A)
                      
                      Report
      of Independent Registered Public Accounting Firm(B)
                      
                      Consolidated
      Statements of Financial Condition - at December 31, 2008 and
      2007(C)
                      
                      Consolidated
      Statements of Income - Years Ended December 31, 2008, 2007 and
      2006(D)
                      
                      Consolidated
      Statements of Comprehensive Income -  Years Ended December 31,
      2008, 2007 and
2006
  76
  (E)
                          
                          Consolidated
      Statements of Changes in Stockholders’ Equity - Years Ended December 31,
      2008, 2007 and 2006(F)
                          
                          Consolidated
      Statements of Cash Flows - Years ended December 31, 2008, 2007 and
      2006(F)
                          
                          Notes
      to Consolidated Financial Statements.(a)(2)
                          
                          Financial Statement
    SchedulesNone.(a)(3)
                          
                          None.(b)
                          
                          Exhibits
      – set forth below(c)
                          
                          Not
      applicable
 Exhibits
 
 3.1
                    
                    Certificate
      of Incorporation of Citizens South Banking Corporation (incorporated
      herein by reference to the Registration Statement on Form S-1 (File No.
      333-91498), originally filed with the Commission on June 28,
      2002)3.2
                    
                    Amended
      Bylaws of Citizens South Banking Corporation4.1
                    
                    Form
      of Common Stock Certificate of Citizens South Banking Corporation
      (incorporated herein by reference to the Registration Statement on Form
      S-1 (File No. 333-91498), originally filed with the Commission on June 28,
      2002)4.2
                    
                    Indenture
      between Citizens South Banking Corporation and Wilmington Trust Company,
      as trustee, dated October 28, 2005. (Incorporated by reference to the
      Current Report on Form 8-K (File No. 0-23971), filed with the Commission
      on November 3, 2005)4.3
                    
                    Certificate
      of Designations of Fixed-Rate Cumulative Perpetual Preferred Stock
      (incorporated herein by reference to the Current Report on Form 8-K (File
      No. 0-23971) filed with the Commission on December 16,
    2008)4.4
                    
                    Warrant
      to Purchase Common Stock of Citizens South Banking Corporation
      (incorporated herein by reference to the Current Report on Form 8-K (File
      No. 0-23971), filed with the Commission on December 12,
    2008)10.1
                    
                    Amended
      and Restated Employment Agreement with Kim S. Price dated November 17,
      2008 (incorporated herein by reference to the Current Report on Form 8-K
      (File No. 0-23971) filed with the Commission on November 20,
      2008)10.2
                    
                    Deferred
      Compensation and Income Continuation Agreement (incorporated by reference
      to the Registration Statement on Form SB-2 (File No. 333-42951),
      originally filed with the Commission on December 22,
  1997)10.3
                    
                    Employee
      Stock Option Plan (incorporated by reference to the Registration Statement
      on Form SB-2 (File No. 333-42951), originally filed with the Commission on
      December 22, 1997)10.4
                    
                    Supplemental
      Executive Retirement Plan (incorporated by reference to the Registration
      Statement on Form SB-2 (File No. 333-42951) filed with the Commission on
      December 22, 1997)
  77
 
 10.5
                  
                  Amended
      and Restated Severance Agreement with Gary F. Hoskins dated November 17,
      2008 (incorporated by reference to the Current Report on Form 8-K (File
      No. 0-23971) filed with the Commission on November 20,
    2008)10.6
                  
                  Amended
      and Restated Severance Agreement with Paul L. Teem, Jr. dated November 17,
      2008 (incorporated by reference to the Current Report on Form 8-K (File
      No. 0-23971) filed with the Commission on November 20,
    2008)10.7
                  
                  Amended
      and Restated Severance Agreement with Michael R. Maguire dated November
      17, 2008 (incorporated by reference to the Current Report on Form 8-K
      (File No. 0-23971) filed with the Commission on November 20,
      2008)10.8
                  
                  Amended
      and Restated Severance Agreement with Daniel M. Boyd, IV dated November
      17, 2008 (incorporated by reference to the Current Report on Form 8-K
      (File No. 0-23971) filed with the Commission on November 20,
      2008)10.9
                  
                  Amended
      and Restated Severance Agreement with V. Burton Brinson, Jr. dated
      November 17, 2008. (incorporated by reference to the Current Report on
      Form 8-K (File No. 0-23971) filed with the Commission on November 20,
      2008)10.10
                  
                  Salary
      Continuation Agreement with Kim S. Price dated January 1, 2004, as amended
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971), filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.11
                  
                  Salary
      Continuation Agreement with Gary F. Hoskins dated January 1, 2004, as
      amended (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971), filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.12
                  
                  Salary
      Continuation Agreement with Paul L. Teem, Jr. dated January 1, 2004, as
      amended (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971) filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.13
                  
                  Salary
      Continuation Agreement with Michael R. Maguire dated January 1, 2004, as
      amended (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971) filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.14
                  
                  Salary
      Continuation Agreement with Daniel M. Boyd, IV dated January 1, 2004, as
      amended (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971) filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.15
                  
                  Salary
      Continuation Agreement with V. Burton Brinson, Jr. dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005)10.16
                  
                  Endorsement
      Split Dollar Agreement with Kim S. Price dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005)10.17
                  
                  Endorsement
      Split Dollar Agreement with Gary F. Hoskins dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16,
  2005)
  78
 
 10.18
                  
                  Endorsement
      Split Dollar Agreement with Paul L. Teem, Jr. dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005)10.19
                  
                  Endorsement
      Split Dollar Agreement with Michael R. Maguire dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005)10.20
                  
                  Endorsement
      Split Dollar Agreement with Daniel M. Boyd, IV dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005)10.21
                  
                  Endorsement
      Split Dollar Agreement with V. Burton Brinson, Jr. dated January 1, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005)10.22
                  
                  Amended
      Deferred Compensation and Income Continuation Agreement with David W.
      Hoyle, Sr. dated March 15, 2004 (incorporated by reference to the Annual
      Report on Form 10-K (File No. 0-23971) filed with the Commission on March
      16, 2005 and the Current Report on Form 8-K (File No. 0-23971) filed with
      the Commission on November 20, 2008)10.23
                  
                  Amended
      Deferred Compensation and Income Continuation Agreement with Ben R.
      Rudisill, II dated March 15, 2005 (incorporated by reference to the Annual
      Report on Form 10-K (File No. 0-23971) filed with the Commission on March
      16, 2005 and the Current Report on Form 8-K (File No. 0-23971) filed with
      the Commission on November 20, 2008)10.24
                  
                  Amended
      Deferred Compensation and Income Continuation Agreement with James J.
      Fuller dated March 15, 2004 (incorporated by reference to the Annual
      Report on Form 10-K (File No. 0-23971) filed with the Commission on March
      16, 2005 and the Current Report on Form 8-K (File No. 0-23971) filed with
      the Commission on November 20, 2008)10.25
                  
                  Amended
      Deferred Compensation and Income Continuation Agreement with Charles D.
      Massey dated March 15, 2004 (incorporated by reference to the Annual
      Report on Form 10-K (File No. 0-23971) filed with the Commission on March
      16, 2005 and the Current Report on Form 8-K (File No. 0-23971) filed with
      the Commission on November 20, 2008)10.26
                  
                  Amended
      Director Retirement Agreement with David W. Hoyle, Sr. dated March 15,
      2004 (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971) filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.27
                  
                  Amended
      Director Retirement Agreement with Ben R. Rudisill, II dated March 15,
      2004 (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971, filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.28
                  
                  Amended
      Director Retirement Agreement with James J. Fuller dated March 15, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971) filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.29
                  
                  Amended
      Director Retirement Agreement with Charles D. Massey dated March 15, 2004
      (incorporated by reference to the Annual Report on Form 10-K (File No.
      0-23971), filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)
  79
  10.30
                  
                  Amended
      Director Retirement Agreement with Eugene R. Matthews, II dated March 15,
      2004 (incorporated by reference to the Annual Report on Form 10-K (File
      No. 0-23971) filed with the Commission on March 16, 2005 and the Current
      Report on Form 8-K (File No. 0-23971) filed with the Commission on
      November 20, 2008)10.31
                  
                  Amended
      and Restated Declaration of Trust among Citizens South Banking
      Corporation, Wilmington Trust Company, as Delaware and Institutional
      Trustee, and the Administrative Trustees named therein, dated October 28,
      2005 (incorporated by reference to the Current Report on Form 8-K (File
      No. 0-23971) filed with the Commission on November 3,
  2005)10.32
                  
                  Citizens
      South Banking Corporation 2008 Equity Incentive Plan (incorporated herein
      by reference to the Appendix A of the Definitive Proxy Statement for the
      2008 Annual Meeting of Stockholders, filed with the Commission on April
      10, 2008)14
                  
                  Code
      of Ethics Policy (incorporated herein by reference to the “Proposal I –
      Election of Directors” section of the Registrant’s Proxy Statement dated
      April 3, 2007)21
                  
                  Subsidiaries
      of Registrant (incorporated herein by reference to the Registration
      Statement on Form S-1 (File No. 333-91498), originally filed with the
      Commission on June 28, 2002)23
                  
                  Consent
      of Cherry, Bekaert & Holland, L.L.P.24
                  
                  Power
      of Attorney (set forth on signature page)31
                  
                  Certification
      of Principal Executive Officer and Principal Financial Officer pursuant to
      Section 302 of the Sarbanes-Oxley Act of 200232
                  
                  Statement
      of Chief Executive Officer and Chief Financial Officer furnished pursuant
      to Section 906 of the Sarbanes-Oxley Act of
2002
  80
  Signatures
 
 Pursuant
to the requirements of Section 13 of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
 
 Citizens
      South Banking CorporationDate:
                          March
      16, 2009
                          
                          By:
                          /s/ Kim S. PriceKim
      S. PricePresident
      and Chief Executive
Officer
 
 Pursuant
to the requirements of the Securities Exchange of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.
 
 By:
                                      /s/ Kim S. Price
                                      
                                      By:
                                      /s/ Gary F. HoskinsKim
      S. Price
                                      
                                      
                                      Gary
      F. HoskinsPresident,
      Chief Executive Officer and
                                      
                                      
                                      Executive
      Vice President, Treasurer andDirector
      (Principal Executive Officer)
                                      
                                      
                                      Chief
      Financial Officer(Principal
      Financial and Accounting Officer)Date:
                                      March 16, 2009
                                      
                                      Date:
                                      March 16, 2009By:
                                      /s/ David W. Hoyle
                                      
                                      By:
                                      /s/ Ben R. Rudisill, IIDavid
      W. Hoyle
                                      
                                      
                                      Ben
      R. Rudisill, IIChairman
                                      
                                      
                                      Vice
      ChairmanDate:
                                      March 16, 2009
                                      
                                      Date:
                                      March 16, 2009By:
                                      /s/ Eugene R. Matthews, II
                                      
                                      By:
                                      /s/ Charles D. MasseyEugene
      R. Matthews, II
                                      
                                      
                                      Charles
      D. MasseyDirector
                                      
                                      
                                      DirectorDate:
                                      March 16, 2009
                                      
                                      Date:
                                      March 16, 2009By:
                                      /s/ James J. FullerJames
      J. FullerDirectorDate:
                                      March 16, 2009
  81