**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, 2007**





**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 incorporation or organization)
            
            (I.R.S.
                Employer 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 o 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 o 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
o .





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




Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). YES o 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 December 31, 2007, as reported by the Nasdaq Global Market, was approximately
      $58.2 million.




As
      of
      March 14, 2008, there were 7,560,644 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, 2007**





**TABLE
      OF CONTENTS**




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













**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, currents 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 14
      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, 2007, Citizens South Bank had 14 full-service branch offices in
      the
      North Carolina Counties of Gaston, Union, Rowan, and Iredell. 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. The Bank's
      corporate headquarters is located in Gastonia, North Carolina, which is located
      in the I-85 corridor, 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, 2007, there were 15 banks and thrifts operating in Gaston County with
      $2.3 billion in deposits. As of June 30, 2007, the Bank had $252.7 million
      in
      deposits in Gaston County, or 11.2% of the total County deposits. This
      represents an annual growth rate of 18.6% and the third highest market share
      in
      Gaston 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, 2007, there were 11 banks and thrifts operating in Union County with
      $1.6 billion in deposits. As of June 30, 2007, the Bank had $105.3 million
      in
      deposits in Union County, or 6.7% of the total County deposits. This represents
      the seventh highest market share in the 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, 2007, there
      were 13 banks and thrifts operating in Rowan County with $1.5 billion in
      deposits. As of June 30, 2007, the Bank had $121.2 million in deposits in Rowan
      County, or 8.2% of the total County deposits representing the fourth highest
      market share in the County.





We
      also
      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, 2007, there were 18 banks and thrifts operating in Iredell County with
      $2.1
      billion in deposits. As of June 30, 2007, the Bank had $106.5 million in
      deposits in Iredell County, or 5.0% of the total County deposits. This
      represents a 22.7% annual growth rate and the seventh highest market share
      in
      the County.





**Employees**




A s
      of
      December 31, 2007, the Company had 133 full-time and 27 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.





**Supervision
      and Regulation**




Citizens
      South Banking Corporation is a unitary savings and loan holding company, 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. Federal law prohibits
      a
      savings and loan holding company from acquiring 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.





2




Citizens
      South Bank is a federally chartered 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 a federally chartered stock savings bank, 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.





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.





**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.




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, 2007, 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,
      2007, Citizens South Bank met the criteria for being considered
“well-capitalized.”




3




OTS **** regulations
      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.





**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.





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.




**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, 2007, Citizens South Bank
        maintained approximately 77% of its portfolio assets in qualified thrift
        investments and satisfied the QTL test as of that date.


4




**Insurance
      of Deposit Accounts.** ** Citizens
      South Bank’s deposits are subject to assessments by the FDIC. These deposit
      accounts are insured by the Deposit Insurance Fund of the FDIC, generally up
      to
      a maximum of $100,000 per separately insured depositor and up to a maximum
      of
      $250,000 for self-directed retirement accounts. Effective March 31, 2006, 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, 2007,
      the
      annualized FICO assessment was equal to 1.14 basis points for each $100 in
      domestic deposits maintained at an institution.





Regulations
      adopted by the FDIC in 2006 established a risk-based assessment system that
      enabled the FDIC to more closely tie each financial institution’s premiums with
      the risk it poses to the Deposit Insurance Fund. Under the new risk-based
      assessment system, which became effective in 2007, the FDIC evaluated the risk
      of each financial institution based on three primary sources of information:
      1)
      its supervisory rating, 2) its financial rations, and 3) its long-term debt
      issuer rating, if the institution has one. The new rates for nearly all of
      the
      financial institution industry vary between five and seven cents for every
      $100
      of domestic deposits. At the same time, the FDIC also adopted final regulations
      designating the reserve ratio for the Deposit Insurance Fund during 2007 at
      1.25% of estimated insured deposits.





**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, 2007, Citizens South
      Bank was in compliance with this requirement.





**Federal
      Reserve System.** The
      Federal Reserve Board regulations require savings banks to maintain
      non-interest-earning reserves against their transaction accounts, such as
      negotiable order of withdrawal and regular checking accounts. At December 31,
      2007, 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.




**The
      USA PATRIOT Act.**  The
      USA
      PATRIOT Act 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.** The
      Sarbanes-Oxley Act was enacted in response to public concerns regarding
      corporate accountability in connection with certain accounting scandals. The
      stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility,
      to provide for enhanced penalties for accounting and auditing improprieties
      at
      publicly traded companies, and to protect investors by improving the accuracy
      and reliability of corporate disclosures pursuant to the securities laws. The
      Sarbanes-Oxley Act generally applies to all companies that file or are required
      to file periodic reports with the Securities and Exchange Commission, under
      the
      Securities Exchange Act of 1934. The Sarbanes-Oxley Act includes specific
      additional disclosure requirements and requires the Securities and Exchange
      Commission and national securities exchanges to adopt extensive additional
      disclosure, corporate governance and other related rules. The Sarbanes-Oxley
      Act
      represents significant federal involvement in matters traditionally left to
      state regulatory systems, such as the regulation of the accounting profession,
      and to state corporate law, such as the relationship between a board of
      directors and management and between a board of directors and its
      committees.





**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.




5




**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**





You
      should consider carefully the following risk factors in evaluating an investment
      in the shares of Citizens South Banking Corporation common stock.





**Changes
      in market 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,
      an
      immediate and sustained decrease of 300 basis points throughout the yield curve
      would decrease its annual net interest income by 2.1% for the period ended
      December 31, 2007. 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.




6




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, 2007, the Company’s investment and mortgage-backed securities
      available for sale totaled $116.4 million. Unrealized losses on securities
      available for sale, net of tax, amounted to $343,000 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.




**A
      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 weaken, we may begin to 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 exposes the Company to increased
      lending risks.**





At
      December 31, 2007, Citizens South Banking Corporation’s portfolio of commercial
      real estate, multifamily, and construction loans totaled $365.4 million, or
      65.26% 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.





**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 our primary market area which is the Charlotte, North Carolina
      metropolitan area. We compete for loan and deposit growth with large banks
      that
      have either a regional or a national presence, other community banks, *de
      novo* financial
      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. We
      expect competition to continue to increase in the future as a result of
      legislative, regulatory, and technological changes and the continuing trend
      of
      consolidation in the financial services industry.





**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 collectibility 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.




7




**The
      Company operates in a highly regulated environment and may be adversely affected
      by changes in laws and regulations.**





Citizens
      South Banking Corporation and its subsidiaries are highly regulated. Our holding
      company is regulated by the OTS and the SEC. Our community banking subsidiary
      is
      also regulated by the OTS. Such regulation and supervision govern the activities
      in which we may engage and are intended primarily for the protection of the
      deposit insurance fund and depositors. Regulatory authorities have extensive
      discretion in connection with their supervisory and enforcement activities,
      including the imposition of restrictions on the operation of an institution,
      the
      classification of assets by the institution and the adequacy of an institution’s
      allowance for loan losses. Any change in such regulation and oversight, whether
      in the form of regulatory policy, regulations or legislation, may have a
      material impact on the Company’s operations. In addition to the risks of
      noncompliance, we are required to dedicate considerable time and monetary
      resources in our efforts to comply with the numerous laws and regulations that
      govern the ways in which we conduct our community banking and mortgage banking
      activities.




**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. The Company currently is repurchasing shares of its
      common stock in a Board-authorized share repurchase program. 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.





8





**ITEM
              1.B.**
            **Unresolved
                Staff Comments**





None.





**ITEM
              2.**
            **Properties**





The
      following table sets forth certain information regarding full-service branch
      offices currently in operation at December 31, 2007. 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 $18.0 million at
      December 31, 2007.





**Location**
            
            ******Principal
                Use******
            
            **Approximate****Facility
                Size**
            
            **Ownerd****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
            
            5,560
            
            OwnedSalisbury,
                North Carolina 28144-4232106
                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 28177-9121




9




**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 2007.





**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 Journal* and
      other
      daily newspapers in the Nasdaq section under the Global Market System listings.
      As of February 1, 2008, the Company had 1,589 stockholders of record (excluding
      the number of persons or entities holding stock in street name through various
      brokerage firms), and 7,660,232 shares outstanding. The following brokers made
      a
      market in the Company’s stock during 2007:





Burke
                Capital Markets, LLC
            1-404-495-5920Citigroup
                Global Markets, Inc.
            1-212-723-7169Fig
                Partners, LLC
            1-404-601-7200Friedman,
                Billings, Ramsey & Co.
            1-800-688-3272FTN
                Midwest Securities Corp.
            1-888-801-3477Howe
                Barnes Investments, Inc.
            1-800-621-2364Hudson
                Securities, Inc.
            1-800-624-0050Keefe,
                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
            1-800-825-9550UBS
                Securities LLC
            1-212-713-2000




10




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.





**2007**
            
            **Quarter
                1**
            
            **Quarter
                2**
            
            **Quarter
                3**
            
            **Quarter
                4**Price
                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





**2006**
            
            **Quarter
                1**
            
            **Quarter
                2**
            
            **Quarter
                3**
            
            **Quarter
                4**Price
                Range:High
            
            $
            13.35
            
            $
            12.80
            
            $
            13.86
            
            $
            13.28Low
            
            
            12.35
            
            
            11.94
            
            
            12.25
            
            
            12.57Dividend
            
            
            0.075
            
            
            0.075
            
            
            0.075
            
            
            0.075Shares
                Repurchased
            
            
            18,263
            
            
            41,000
            
            
            52,825
            
            
            95,000Avg.
                Price Paid Per Share
            
            $
            12.15
            
            
            12.43
            
            $
            12.87
            
            $
            12.91




The
      Company’s dividend payout ratio was 43% in 2007, compared to 44% in 2006. 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. Given the Company’s strong
      capital position and its access to liquidity, there are no expected changes
      to
      the Company’s current dividend policy.




11





Set
      forth
      herein under 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, 2002, as reported on
      the Nasdaq Stock Market, through December 31, 2007, (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.









***Period
                Ending******Index***
            
            **12/31/02**
            
            **12/31/03**
            
            **12/31/04**
            
            **12/31/05**
            
            **12/31/06**
            
            **12/31/07**Citizens
                South Banking Corporation
            
            
            100.00
            
            
            139.35
            
            
            145.34
            
            
            124.34
            
            
            137.85
            
            
            110.64Russell
                2000
            
            
            100.00
            
            
            147.25
            
            
            174.24
            
            
            182.18
            
            
            215.64
            
            
            212.26SNL
                Southeast Thrift Index
            
            
            100.00
            
            
            151.65
            
            
            179.27
            
            
            163.14
            
            
            191.73
            
            
            82.56




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.





12




**b.** Not
      applicable.





**c.** During
      the three-month period ended December 31, 2007, the Company repurchased the
      following shares of stock.




**2007**
            **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
                Plan**October
            38,300
            $12.39
            0
            200,000November
            81,900
            $11.80
            64,648
            135,352December
            42,000
            $11.38
            42,000
            93,352**Total**
            **163,200**
            **$11.76**
            **106,648**
            **93,352**





As
      of
      December 31, 2007, the Company had repurchased a total of 3,111,083 shares,
      or
      34.3% of the outstanding shares of common stock, at an average price of $13.17.
      This stock was repurchased under a series of repurchase programs that have
      been
      authorized by the Board of Directors over the past several years. The most
      recent repurchase authorization was granted by the Board of Directors on October
      22, 2007, for the repurchase of up to 200,000 shares, or approximately 2.5%
      of
      the Company’s then outstanding shares of common stock. These repurchases may be
      carried out through open market purchases, block trades, and negotiated private
      transactions. The stock may be repurchased on an ongoing basis and will be
      subject to the availability of stock, general market conditions, the trading
      price of the stock, alternative uses for capital, and the Company’s financial
      performance. As of December 31, 2007, the Company had repurchased a total of
      106,648 shares at an average price of $11.63 per share and had 93,392 shares
      remaining to be repurchased under this plan. The Company will consider
      repurchasing additional shares of common stock of the Company at prices
      management considers to be attractive and in the best interests of both the
      Company and its stockholders. Any repurchased shares will be held as treasury
      stock and will be available for general corporate purposes **.**





13





**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.





**At
                and for the years ended December 31,****2007****(1)**
            
            **2006****(1****)**
            
            **2005****(1)**
            
            **2004**
            
            **2003***(Dollars
                in Thousands, Except per Share Data)***Income
                Statement Data:**Interest
                income
            
            $
            46,735
            
            $
            42,919
            
            $
            26,948
            
            $
            21,110
            
            $
            21,969Interest
                expense
            
            
            26,500
            
            
            22,279
            
            
            11,469
            
            
            7,943
            
            
            8,732Net
                interest income
            
            
            20,235
            
            
            20,640
            
            
            15,479
            
            
            13,167
            
            
            13,237Provision
                for loan losses
            
            
            1,290
            
            
            1,165
            
            
            985
            
            
            330
            
            
            60Net
                interest income after provision for loan losses
            
            
            18,945
            
            
            19,475
            
            
            14,494
            
            
            12,837
            
            
            13,177Noninterest
                income
            
            
            6,562
            
            
            6,141
            
            
            4,441
            
            
            4,824
            
            
            5,561Noninterest
                expense
            
            
            17,895
            
            
            17,544
            
            
            14,339
            
            
            13,629
            
            
            13,891Income
                before income taxes
            
            
            7,612
            
            
            8,072
            
            
            4,596
            
            
            4,032
            
            
            4,847Income
                tax expense
            
            
            1,947
            
            
            2,617
            
            
            1,323
            
            
            1,077
            
            
            1,456Net
                income
            
            $
            5,665
            
            $
            5,455
            
            $
            3,273
            
            $
            2,955
            
            $
            3,391**Per
                Share Data:**Basic
                net income
            
            $
            0.74
            
            $
            0.68
            
            $
            0.45
            
            $
            0.39
            
            $
            0.39Diluted
                net income
            
            
            0.73
            
            
            0.67
            
            
            0.45
            
            
            0.38
            
            
            0.39Cash
                dividends declared
            
            
            0.32
            
            
            0.30
            
            
            0.28
            
            
            0.26
            
            
            0.24Year-end
                book value
            
            
            11.05
            
            
            10.61
            
            
            10.16
            
            
            9.74
            
            
            10.11**Balance
                Sheet Data:**Total
                assets
            
            $
            779,140
            
            $
            743,370
            
            $
            701,094
            
            $
            508,961
            
            $
            495,751Loans
                receivable, net
            
            
            553,812
            
            
            509,638
            
            
            468,232
            
            
            314,124
            
            
            295,026Mortgage-backed
                and related securities
            
            
            69,893
            
            
            60,691
            
            
            70,236
            
            
            81,169
            
            
            89,168Investment
                securities
            
            
            46,519
            
            
            65,326
            
            
            53,429
            
            
            52,407
            
            
            56,233Deposits
            
            
            590,765
            
            
            562,802
            
            
            517,544
            
            
            374,744
            
            
            342,446Borrowings
            
            
            96,284
            
            
            85,964
            
            
            91,342
            
            
            55,772
            
            
            58,981Stockholders’
                equity
            
            
            84,033
            
            
            85,961
            
            
            84,258
            
            
            72,394
            
            
            87,699**Performance
                Ratios:**Return
                on average assets
            
            
            0.75
            %
            
            0.76
            %
            
            0.60
            %
            
            0.59
            %
            
            0.69
            %Return
                on average equity
            
            
            6.68
            
            
            6.42
            
            
            4.40
            
            
            3.78
            
            
            3.61Avg.
                interest-earning assets to avg. interest-bearing
                liabilities
            
            
            107.26
            
            
            106.53
            
            
            109.40
            
            
            110.96
            
            
            118.65Noninterest
                expense to average total assets
            
            
            2.38
            
            
            2.45
            
            
            2.64
            
            
            2.73
            
            
            2.81Interest
                rate spread
            
            
            2.84
            
            
            3.10
            
            
            3.03
            
            
            2.78
            
            
            2.57Net
                interest margin(2)
            
            
            3.14
            
            
            3.33
            
            
            3.26
            
            
            2.98
            
            
            2.94**Asset
                Quality Ratios:**Allowance
                for loan losses to total loans
            
            
            1.10
            %
            
            1.12
            %
            
            1.08
            %
            
            0.95
            %
            
            1.00
            %Net
                charge-offs to average loans
            
            
            0.17
            
            
            0.10
            
            
            0.12
            
            
            0.09
            
            
            0.03Nonperforming
                loans to total loans
            
            
            0.32
            
            
            0.58
            
            
            0.54
            
            
            0.30
            
            
            0.18Nonperforming
                assets to total assets
            
            
            0.30
            
            
            0.42
            
            
            0.53
            
            
            0.34
            
            
            0.14**Capital
                Ratios:**Average
                equity to average total assets
            
            
            11.26
            %
            
            11.86
            %
            
            13.69
            %
            
            15.64
            %
            
            18.96
            %Equity
                to assets at year end
            
            
            10.79
            
            
            11.56
            
            
            12.02
            
            
            14.22
            
            
            17.69Dividend
                payout ratio
            
            
            43.24
            
            
            44.12
            
            
            62.22
            
            
            66.67
            
            
            61.54







(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 $557, $191, $155, $0, and $0 for 2007, 2006, 2005, 2004,and
                2003,
                respectively.





14





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





**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 savings bank headquartered in Gastonia, North
      Carolina. The Company’s principal business activities are overseeing and
      directing the business of the Bank and investing the net stock offering proceeds
      retained by the Company. 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 14 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).





Our
      primary business strategy since our initial public stock offering in 1998 has
      been to transform the Bank from a traditional savings bank to a full-service
      community bank, offering a complete array of both commercial and retail loan
      and
      deposits, wealth management services, 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 nonresidential real
      estate and construction loans, 2) originated substantially all fixed-rate
      one-to-four family residential loans as a broker for a third party, and 3)
      focused its deposit gathering efforts on core deposits (demand deposit accounts,
      money market accounts, and savings accounts). As a result, nonresidential real
      estate and construction loans comprised approximately 65% of the Company’s loan
      portfolio at December 31, 2007, compared to approximately 39% at December 31,
      2003. Also, during the same period, the Company’s portfolio of one-to-four
      family residential loans decreased from 34% of the Company’s loan portfolio at
      December 31, 2003, to 14% of the Company’s loan portfolio at December 31, 2007.
      Core deposits have increased as a percentage of total deposits from 37.6% at
      December 31, 2003 to 41.3% at December 31, 2007. Management expects to continue
      to execute this business strategy in 2008.





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. Trinity had three offices located in Union
      County, North Carolina, which had the fastest population growth of any county
      in
      North Carolina based on the most current information available at the time
      of
      the acquisition. The combined bank had 14 full-service locations and ranked
      8 th in the
      Charlotte Metropolitan Statistical Area in deposit market share as of December
      31, 2007.





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 will 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.





15




In
      order
      to provide financing for the cash portion of the Trinity acquisition, on October
      28, 2005, the Company completed a private placement of an aggregate amount
      of
      $15.0 million in trust preferred securities, liquidation amount of $1,000 per
      security (the “Preferred Securities”), through a newly formed Delaware statutory
      trust subsidiary, CSBC Statutory Trust I (the “Trust”). In connection with the
      issuance of the Preferred Securities, on October 28, 2005, the Company entered
      into an Indenture by and between the Company and Wilmington Trust Company,
      as
      trustee. The Preferred Securities mature on December 15, 2035, but may be
      redeemed beginning December 15, 2010, if the Company exercises its rights to
      redeem the Debentures. The Preferred Securities require quarterly interest
      payments to the holders of the Preferred Securities, initially at a fixed rate
      of 6.095% through December 2010, and thereafter at a variable rate of
      three-month LIBOR plus 1.57%, reset quarterly. Additional information regarding
      the Preferred Securities may be obtained by reviewing the Form 8-K filed with
      the Securities and Exchange Commission on November 4, 2005.





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. 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.





Certain
      actions were taken that adversely impacted our results of operations for the
      years ended December 31, 2006 and 2005. In 2005 we acquired Trinity Bank,
      resulting in merger and computer conversion related expenses of $384,000.
      Additional merger and conversion expenses totaling $57,000 were incurred in
      2006.





Net
      income was $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. 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.


16





**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. 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.”





Management
      has established a systematic method for periodically evaluating the credit
      quality of the loan portfolio in order to establish an allowance for loan
      losses. The methodology is set forth in a formal policy and includes a review
      of
      all loans in the portfolio on which full collectibility may or may not be
      reasonably assured. The loan review considers among other matters, the estimated
      fair value of the collateral, economic conditions, historical loan loss
      experience, our knowledge of inherent losses in the portfolio that are probable
      and 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 collectibility. Management
      believes this is a critical accounting policy because this evaluation involves
      a
      high degree of complexity and requires us to make subjective judgments that
      often require assumptions or estimates about various matters.





**Other-Than-Temporary
      Impairment of Securities.** Management
      periodically reviews all investment securities with significant declines in
      fair
      value for potential other-than-temporary impairment pursuant to the guidance
      provided by SFAS No. 115, *Accounting
      for Certain Investments in Debt and Equity Securities.* In
      November 2006, the 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.
      115 *Accounting for Certain Investments in Debt and Equity Securities,* No.
      124, *Accounting
      for Certain Investments Held by Not-for-Profit Organizations,* and
      APB
      Opinion 18, *The
      Equity Method of Accounting for Investments in Common Stock.*





Effective
      June 30, 2007, management evaluated the Company’s investment portfolio and
      determined that a $162,000 “other-than-temporary” impairment existed on a
      $305,000 equity investment in a closely held company. The impairment was
      considered to be “other-than-temporary” due to the closely held company’s
      continuing operating losses and deteriorating book value. The Company’s
      remaining equity interest in the closely held company amounts to $143,000. ** Effective
      December 31, 2007, 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 additional
      unrealized losses as “other-than-temporary” as of December 31, 2007.





17





**Comparison
      of Financial Condition for the Years Ended December 31, 2007 and
      2006**





Total
      assets increased by $35.7 million, or 4.8%, from $743.4 million at December
      31,
      2006, to $779.1 million at December 31, 2007. The majority of this growth was
      due to a $44.6 million, or 8.6%, increase in outstanding loans from $515.4
      million at December 31, 2006, to $560.0 million at December 31, 2007. Most
      of
      the Company’s loan growth was in loans secured by commercial real estate. During
      2007, these loans, which include construction loans, multifamily residential
      loans, and nonresidential real estate loans, increased by $36.0 million, or
      10.9%, to $365.4 million at December 31, 2007. These loans are typically secured
      by owner-occupied professional office buildings, retail properties, churches,
      speculative residential properties, or residential subdivisions located in
      the
      Charlotte, North Carolina metropolitan area, which is the Company’s primary
      lending area. Management does not generally pursue commercial real estate loans
      that are secured by hotels, motels, golf courses, or resort properties.
      Management plans to continue to emphasize the origination of commercial real
      estate loans in the Company’s primary lending area. Also during 2007, the
      Company’s portfolio of one-to-four family residential loans decreased from $83.3
      million to $78.6 million due to normal prepayments and principal amortization.
      The Company originates and closes substantially 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. 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.” Management expects that in 2008 the
      Company’s portfolio of one-to-four family mortgage loans will continue to
      decrease as most new loan originations will be made as a broker for the third
      party. During 2007, consumer loans increased by $12.2 million, or 17.3%, to
      $82.4 million at December 31, 2007. Approximately $67.0 million, or 81.3%,
      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 secured
      by owner-occupied residential properties located in the Company’s normal lending
      area. Management plans to continue to grow its portfolio of consumer loans
      in
      2008 by implementing an incentive plan for its retail branch managers and
      creating marketing campaigns directed toward growing outstanding home equity
      loans and lines of credit. Commercial business loans increased by $1.4 million,
      or 4.3%, to $33.6 million. Management expects similar growth of its commercial
      business loans in 2008.





In
      order
      to facilitate continued loan growth during 2008, the Company plans to open
      a
      full-service office in Rock Hill, South Carolina during the first quarter of
      2008. Also, the Company added one commercial lender and one business banker
      during the fourth quarter of 2007. However, the Company’s ability to grow the
      existing loan portfolio is largely dependent on the local economy of the
      Charlotte metropolitan area. Management will also continue to focus on
      maintaining the current credit quality of the portfolio and will not forsake
      the
      credit quality of the loan portfolio for additional growth.





Cash
      and
      cash equivalents increased by $3.5 million, or 13.4%, from $26.2 million at
      December 31, 2006, to $29.7 million at December 31, 2007. This increase was
      primarily due to an $18.8 million decrease in investment securities, a $28.0
      million increase in deposits, a $10.3 million increase in borrowed money, net
      proceeds of $1.3 million from the sale of real estate acquired through
      foreclosure, loans and fixed assets, and net income of $5.7 million in 2007.
      These increases in cash and cash equivalents were partly offset by loan growth
      of $44.6 million, a $9.2 million increase in mortgage-backed securities, stock
      repurchases of $6.4 million, and the payment of $2.5 million in cash dividends
      during 2007. Management expects that cash and cash equivalents will decrease
      in
      2008 as excess liquidity is invested in new loans and higher-yielding investment
      securities.





18





Investment
      securities decreased by $18.8 million, or 28.8%, from $65.3 million at December
      31, 2006, to $46.5 million at December 31, 2007. This decrease was primarily
      the
      result of the sale of $8.7 million in investment securities and $19.4 million
      in
      normal maturities and calls. Approximately $5.7 million of the investments
      sold
      were long-term AAA-rated bank-qualified municipal securities that were issued
      by
      various municipalities that carried an underlying credit rating of less than
      AA.
      These securities were insured as AAA-rated obligations by large bond insurance
      companies that had a higher than expected exposure to sub-prime investments,
      resulting in a potential downgrade from the credit rating agencies from their
      current AAA rating. The sale of these municipal securities was effected in
      order
      to protect the Company from a potential downgrade from the current AAA rating,
      that could have resulted in a possible “other-than-temporary impairment” on
      these securities. As of December 31, 2007, the Company’s municipal bond
      portfolio totaled $31.8 million. Management expects that the remaining municipal
      bond portfolio has sufficient credit support from the underlying municipalities
      and diversity among the bond insurance companies to adequately mitigate any
      adverse effects of possible downgrades from the current AAA rating of one or
      more of the bond insurance companies. This decrease in investment securities
      was
      partly offset by the purchase $9.8 million in investment securities in 2007.
      Mortgage-backed securities increased by $9.2 million, or 15.2%, from $60.7
      million at the end of 2006, to $69.9 million at the end of 2007. This increase
      was primarily due to the purchase of $28.7 million of mortgage-backed
      securities, which was partly offset by the maturity and principal amortization
      of $12.4 million of mortgage-backed securities and the sale of $8.3 million
      of
      mortgage-backed securities during the year. Management expects that in 2008
      the
      principal amortization of its mortgage-backed securities portfolio will be
      higher than the principal amortization experienced in 2007 as mortgage loan
      interest rates are expected to decrease in 2008. Management plans to reinvest
      the proceeds received from mortgage-backed securities into higher-yielding
      commercial and consumer loans as cash flows are generated from these investments
      through maturities and principal and interest payments.





Premises
      and equipment decreased by $322,000, or 1.5%, to $18.0 million at December
      31,
      2007. Normal depreciation during 2007 amounted to $1.2 million. In addition,
      in
      2007 the Company sold the vacant operations center of the former Citizens Bank
      and a right-of-way parcel of land for approximately $801,000 and purchased
      a
      parcel of land for future expansion for $826,000. Plans are underway to open
      a
      full-service office in York County, South Carolina in the first quarter of
      2008
      in a leased facility. Also in 2008, the Company will be pursuing additional
      branch sites in its existing market area as opportunities arise.





Total
      liabilities increased by $37.7 million, or 5.7%, from $657.4 million at December
      31, 2006, to $695.1 million at December 31, 2007. This increase was primarily
      due a $30.0 million, or 5.0%, increase in deposits. Total deposits increased
      from $562.8 million at December 31, 2006, to $590.8 million at December 31,
      2007. Core deposits, which management considers checking accounts, money market
      accounts, and savings accounts, increased by $19.5 million, or 8.7%, during
      2007. Management is committed to increasing core deposits and building new
      and
      enhancing existing customer relationships through improving technology,
      expanding its branch network and focused marketing efforts. In 2007 the Company
      developed two new products for both its commercial and retail customers that
      significantly contributed to the strong growth in core deposit in 2007. The
      first product is our remote deposit capture, which gives our commercial
      customers the ability to make deposits 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 includes a new “no strings attached”
high-yield checking account product that compares favorably with some of our
      competitors’ products that offer a higher interest rate, but includes numerous
      conditions in order to receive the higher rate. In addition, we now offer
      all-day banking, which eliminated the 2:00 pm cutoff for current day processing
      of deposits. In 2008 we plan to continue to market these and other core products
      in our local area through normal media outlets and through incentive plans
      paid
      to employees for new core customer accounts. Time deposits increased by $8.5
      million, or 2.5%, to $347.1 million at December 31, 2007. 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, 2007, approximately $3.6 million, or
      0.6% of total deposits, were brokered time deposits.





Borrowed
      money, which includes subordinated debt and retail repurchase agreements,
      increased by $10.3 million, or 12.0%, from $86.0 million at the end of 2006
      to
      $96.3 million at the end of 2007. 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.





19




Total
      stockholders’ equity decreased by $2.0 million, or 2.2%, from $86.0 million at
      December 31, 2006 to $84.0 million at December 31, 2007. This decrease was
      primarily due to the repurchase of 515,637 shares of common stock for $6.4
      million at an average price of $12.53 per share. These shares were repurchased
      as a part of stock repurchase plans announced in November 2007, January 2007
      and
      January 2006. The January 2006 repurchase plan provided for the repurchase
      of
      200,000 shares, or 2.5% of the outstanding shares. All of the shares authorized
      under this plan were repurchased by January 2007. The January 2007 repurchase
      plan provided for the repurchase of 400,000 shares, or 5.0% of the outstanding
      shares. All of the shares authorized under this plan were repurchased by
      November 2007. The November 2007 repurchase plan provided for the repurchase
      of
      200,000 shares, or 2.5% of the outstanding shares. As of December 31, 2007,
      the
      Company had repurchased 106,648 shares under the plan and had 93,352 shares
      remaining to be repurchased. Management plans to continue to repurchase shares
      of common stock in the Company at prices that are considered to be attractive
      and in the best interests of both the Company and its stockholders. The decrease
      in total stockholders’ equity during 2007 was also partly offset by the payment
      of $2.5 million in cash dividends, or $0.32 per share. These decreases in
      stockholders’ equity were partly offset by $5.7 million in net income earned in
      2007 and a $648,000 decrease in accumulated net unrealized losses on investments
      available for sale.





**Results
      of Operations**





The
      following discussion relates to operations for the year ended December 31,
      2007,
      compared to the year ended December 31, 2006, as well as the year ended December
      31, 2006, compared to the year ended December 31, 2005. The net income of the
      Company is heavily dependent upon net interest income. Net interest income
      is
      the difference between the interest earned on loans, investment and
      mortgage-backed securities, and interest-bearing deposits in other banks, offset
      by the interest paid on deposits and borrowings.





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





Net
      income was $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 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 2.84%. 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 7.72% 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.





20




Interest
      earned on interest-bearing bank balances decreased by $392,000, or 46.8%, to
      $446,000 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 4.76%. 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 5.20% 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. Management expects the levels of investment and
      mortgage-backed securities will decline during 2008, with the proceeds of any
      sales, maturities, and normal amortization to be used to fund additional loan
      originations, stock repurchases, and repayments on maturing borrowed money.





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.
      Management expects that short-term interest rates will continue to decline
      in
      2008, resulting in lower costs of funds for deposits and borrowings. The Company
      may increase the level of borrowings to provide liquidity for operating
      purposes, to purchase investment securities, repurchase stock, etc. If these
      borrowing levels increase, there will be a corresponding increase in interest
      expense.





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.




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 2008, resulting in steady mortgage
      lending activity for 2008. 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 2008.
      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 2008 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.




21




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 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.
      Additional staffing is expected in 2008 due to the expected opening of a new
      full-service branch office in the first quarter of 2008. 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 Company plans
      to open a full-service office in Rock Hill, South Carolina in the first quarter
      of 2008 which will be located in a leased building and will replace the existing
      loan production office in Rock Hill. 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. Estimated amortization expense
      in 2008 is expected to be $512,000, compared to $629,000 in 2007. Also, in
      2007,
      there were no merger-related expenses as compared to $57,000 in 2006. The
      expenses incurred in 2006 were attributable to the acquisition of Trinity Bank
      in October of 2005.





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.
      Management expects to decrease its level of income generated from tax-advantaged
      sources in 2008, resulting in an increase in the effective tax rate for
      2008.




**Comparison
      of Results of Operations for the Years Ended December 31, 2006 and
      2005**





Net
      income was $5.5 million, or $0.67 per diluted share, for the year ended December
      31, 2006, compared to $3.3 million, or $0.45 per diluted share, for the year
      ended December 31, 2005. The earnings resulted in a return on average equity
      of
      6.42% in 2006, compared to 4.40% in 2005, and a return on average assets of
      0.76% in 2006, compared to 0.60% in 2005.




Net
      interest income increased by $5.2 million, or 33.3%, to $20.6 million during
      the
      year ended December 31, 2006, compared to $15.5 million for the year ended
      December 31, 2005. This increase was largely due to the fact that the Company
      received the benefit of the Trinity acquisition for only two months in 2005
      compared to the full 12 months in 2006. This increase was also due in part
      to a
      seven basis point increase in the average net interest rate spread from 3.03%
      for 2005 to 3.10% for 2006. This increase was largely due to a series of 25
      basis point increases in the federal funds rate by the Federal Reserve Board
      during the first half of 2006 that resulted in a 100 basis point increase in
      the
      prime-lending rate during the year to 8.25% at December 31, 2006. Approximately
      54% of the Company’s loan portfolio repriced each month at December 31, 2006,
      the majority of which was tied to the prime lending rate. This also contributed
      to a seven basis point increase in the Company’s net interest margin from 3.26%
      in 2005 to 3.33% in 2006. During 2006, the Company’s ratio of average
      interest-earning assets to average interest-bearing liabilities decreased from
      109.40% in 2005 to 106.53% in 2006. This declining ratio of average
      interest-earning assets to average interest-bearing liabilities, which partly
      offset the positive effect of the increased net interest rate spread, was due
      primarily due to the repurchase of 207,088 shares of common stock for $2.6
      million.




22




Interest
      income for the year ended December 31, 2006 increased by $16.0 million, or
      59.3%, to $42.9 million. This increase was largely due to the fact that the
      Company received the benefit of the Trinity acquisition for only two months
      in
      2005 compared to the full 12 months in 2006. Partly as a result of the
      acquisition, average interest-earning assets increased by $145.6 million, or
      30.4%, from $479.5 million in 2005 to $625.1 million in 2006. In addition,
      due
      to increases in the prime lending rate during 2006, the yield on
      interest-earnings assets increased by 125 basis points to 6.90% for 2006.
      Average outstanding loans increased by $145.6 million, or 41.9%, from $347.7
      million to $493.3 million, while the average yield on loans increased from
      6.36%
      to 7.59% from 2005 to 2006. These changes were primarily the result of acquiring
      $112.8 million in loans in the Trinity acquisition in October 2005, organic
      loan
      growth of $42.2 million during the year, and a 100 basis point increase in
      the
      prime-lending rate during the year. As a result, interest income on loans
      increased by $15.3 million, or 69.2%, to $37.4 million in 2006.





Interest
      earned on interest-bearing bank balances increased by $375,000, or 81.0%, to
      $838,000 in 2006. The average balance of interest-bearing bank balances
      increased by $3.3 million, or 24.8%, to $16.7 million and the average yield
      on
      these deposits increased by 155 basis points to 5.01%. Interest earned on
      investment securities, including tax-equivalent adjustments of $191,000 in
      2007
      and $155,000 in 2006, increased by $430,000, or 24.5%, to $2.1 million in 2006.
      This increase in interest income was primarily due to a $5.4 million, or 12.0%,
      increase in the average outstanding balance of investment securities to $50.5
      million in 2006. The average yield on investment securities increased by 43
      basis points to 4.33% for 2006 due to the increased level of short-term interest
      rates during 2006. Interest income from mortgage-backed securities decreased
      by
      $118,000, or 4.3%, to $2.6 million in 2006. This decrease was largely due to
      an
      $8.7 million, or 11.9%, decrease in the average balance of mortgage-backed
      securities to $64.5 million during 2006. Also, during 2006, the average yield
      on
      mortgage-backed securities increased from 3.76% to 4.08%, due in part to slower
      prepayment levels resulting from higher mortgage interest rates during the
      year.





Interest
      expense increased $10.8 million, or 94.3%, to $22.3 million for the year ended
      December 31, 2006. This increase was largely due to the fact that the Company
      received the benefit of the Trinity acquisition for only two months in 2005
      compared to the full 12 months in 2006. Partly as a result of the acquisition,
      average interest-bearing liabilities increased by $148.5 million, or 33.9%,
      from
      $438.3 million in 2005 to $586.8 million in 2006. In addition, the average
      cost
      of funds increased by 118 basis points to 3.80% in 2006. Interest expense on
      deposits increased $9.1 million, or 101.7%, to $18.1 million in 2006. This
      increase was primarily due to a $128.5 million, or 34.5%, increase in average
      deposits in 2006 and a 120 basis point increase in the cost of deposits to
      3.62%
      in 2006. Average deposits increased due to $135.6 million in deposits acquired
      from Trinity in October 2005 and $45.3 million in organic growth. The cost
      of
      funds increased due to the 100 basis point increase in short-term rates during
      2006. Interest paid on borrowed money increased by $1.7 million, or 67.6%,
      to
      $4.2 million in 2006. Average borrowings increased by $20.0 million, or 30.2%,
      to $86.2 million for 2006, while the average rate paid on borrowings increased
      from 3.76% in 2005 to 4.85% in 2006 due to higher market interest rates in
      2006.





The
      Company provided $1.2 million and $985,000 in loan loss provisions for the
      years
      ended December 31, 2006 and 2005, respectively. The allowance for loan losses
      as
      a percentage of loans was 1.12% at December 31, 2006, and 1.08% at December
      31,
      2005. The provision for loan losses increased due to strong organic growth
      in
      the Company’s loan portfolio of $42.1 million, coupled with net charge-offs of
      $505,000 during the year. The level of nonperforming loans increased by
      $460,000, to $3.1 million at December 31, 2006. As a result, the ratio of
      nonperforming loans to net loans increased from 0.54% at December 31, 2005,
      to
      0.58% at December 31, 2006. Also, real estate owned decreased by $1.0 million
      to
      $139,000 at December 31, 2006. The properties acquired through foreclosure
      consist of one one-to-four family residential property and one residential
      lot.
      These properties are in various stages of disposition. As a result, the ratio
      of
      nonperforming assets to total assets decreased from 0.53% at December 31, 2005,
      to 0.42% at December 31, 2006.




For
      the
      year ended December 31, 2006, noninterest income increased by $1.7 million,
      or
      38.3%, from $4.4 million to $6.1 million. The Company experienced increases
      of
      $369,000 in fee income on deposit accounts, $709,000 from mortgage banking
      and
      lending activities, $66,000 in dividends on FHLB stock, $148,000 from the cash
      value of bank-owned life insurance, $124,000 increase in the fair value
      adjustment on deferred compensation assets, and $181,000 in other noninterest
      income. These increases in noninterest income were largely due to the fact
      that
      the Company received the benefit of the Trinity acquisition for only two months
      in 2005 compared to the full 12 months in 2006. The increase in mortgage-banking
      and loan fee income was also due to an increased amount of fee income from
      commercial loans coupled with strong mortgage-banking activity during 2006.
      Fee
      income on deposit accounts was higher largely due to the increased number of
      accounts which resulted in an increase in fees generated from overdrawn checking
      accounts. Management believes that a continued focus on growing retail and
      commercial checking accounts will result in a moderate improvement in fee income
      on deposit accounts in 2006. The increase on dividends on FHLB stock is directly
      related to the rate paid by the FHLB and the number of outstanding shares (based
      on outstanding advances). The increase 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.




23




Net
      gain
      on sale of assets increased by $7,000, or 11.9%, to $69,000 in 2006. 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 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.
      The proceeds from these sales were used to generate funds to repurchase shares
      of stock and originate loans. During the year ended December 31, 2005, the
      Company sold $9.4 million in investment securities and $30.3 million in
      mortgage-backed securities at a net gain of $17,000. Most of these sales were
      from securities acquired from Trinity. These proceeds were primarily used to
      repurchase additional investments that were more reflective of the Company’s
      investment philosophy of investing in shorter-term investment securities and
      mortgage-backed securities that provide a stable level of cash flow to fund
      future loan growth. The Company also recognized a $45,000 net gain on sale
      of
      both $517,000 of other real estate owned and $191,000 of premises and equipment.





Noninterest
      expense increased by $3.2 million, or 22.3%, from $14.3 million in 2005 to
      $17.5
      million in 2006. This increase was largely due to the acquisition of Trinity,
      which added approximately 35 employees and three additional full-service
      offices, and the opening of a new full-service office in Belmont, North
      Carolina. As a result, compensation expense increased by $2.1 million, or 29.2%,
      from $7.2 million in 2005 to $9.4 million in 2006. The Company integrated the
      back-office functions of Trinity during the first quarter of 2006, which
      resulted in a decrease of eight employees. In addition, the Company opened
      a
      loan production office in Rock Hill, South Carolina, during the first quarter
      of
      2006, which is staffed by two additional employees. Occupancy expense increased
      by $513,000, or 24.4%, primarily due to the addition of four full-service
      offices from the beginning of 2005 to the end of 2006. Advertising expenses
      increased by $205,000, or 71.3%, from $287,000 in 2005 to $492,000 in 2006.
      This
      increase was primarily due to additional marketing expenses associated with
      entering the Union County market via the acquisition of Trinity Bank. The
      amortization of core deposit premium increased by $325,000, or 79.5%, to
      $734,000 in 2006. This increase was due to the amortization of the $2.3 million
      core deposit intangible that resulted from the Trinity Bank acquisition which
      is
      being amortized over an eight-year period on an accelerated basis. Estimated
      amortization expense in 2007 is expected to be $629,000. The Company also
      experienced moderate increases in telephone expense ($66,000), office supplies
      ($17,000), professional services ($10,000), deposit insurance ($11,000), and
      other noninterest expenses ($267,000). These increases were primarily
      attributable to the acquisition of Trinity Bank.





These
      increases in noninterest expenses were partly offset by a $327,000 decrease
      in
      merger related expenses. The Company experienced merger and conversion expenses
      in 2005 in the amount of $384,000 compared to $57,000 in 2006. In addition,
      data
      processing expense decreased by $6,000, or 1.6%, due to the consolidation during
      the first quarter of 2006 of the two data processing systems resulting from
      the
      merger.





The
      Company’s provision for income taxes was $2.6 million and $1.3 million for the
      years ended December 31, 2006 and 2005, respectively. The change was primarily
      due to a $3.5 million increase in pretax income. The effective tax rate
      increased from 28.8% to 32.4% due to a smaller 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.





24





**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, 2007, 2006 and 2005. 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. Tax equivalent adjustments
      using a 34% tax rate were made to interest income on tax-exempt investment
      securities, such as municipal bonds, in the amounts of $557,000, $191,000,
      and
      $155,000 for 2007, 2006 and 2005, respectively.





**Average
      Balances and Net Interest Income Analysis**


**December
                  31, 2007**
              
              **December
                  31, 2006**
              
              **December
                  31, 2005****Interest**
              
              **Average**
              
              
              
              **Interest**
              
              **Average**
              
              
              
              **Interest**
              
              **Average****Average**
              
              **Income/**
              
              **Yield/**
              
              **Average**
              
              **Income/**
              
              **Yield/**
              
              **Average**
              
              **Income/**
              
              **Yield/****Balance**
              
              **Expense**
              
              **Cost**
              
              **Balance**
              
              **Expense**
              
              **Cost**
              
              **Balance**
              
              **Expense**
              
              **Cost**(Dollars
                  in Thousands)**Assets:**Interest-earning
                  assets:Loans
                  receivable(1)
              
              $
              526,913
              
              $
              40,679
              
              
              7.72
              %
              $
              493,324
              
              $
              37,448
              
              
              7.59
              %
              $
              347,720
              
              $
              22,128
              
              
              6.36
              %Interest-bearing
                  bank deposits
              
              
              9,426
              
              
              446
              
              
              4.73
              
              
              16,715
              
              
              838
              
              
              5.01
              
              
              13,394
              
              
              463
              
              
              3.46Investment
                  securities(2)
              
              
              62,044
              
              
              3,227
              
              
              5.20
              
              
              50,537
              
              
              2,188
              
              
              4.33
              
              
              45,113
              
              
              1,758
              
              
              3.90Mortgage-backed
                  securities
              
              
              64,595
              
              
              2,940
              
              
              4.55
              
              
              64,549
              
              
              2,636
              
              
              4.08
              
              
              73,283
              
              
              2,754
              
              
              3.76Total
                  interest-earning assets(2)
              
              
              662,978
              
              
              47,292
              
              
              7.13
              
              
              625,125
              
              
              43,110
              
              
              6.90
              
              
              479,510
              
              
              27,103
              
              
              5.65Noninterest-earning
                  assets
              
              
              90,107
              
              
              
              
              
              
              
              
              91,809
              
              
              
              
              
              
              
              
              63,801Total
                  assets
              
              $
              753,085
              
              
              
              
              
              
              
              $
              716,934
              
              
              
              
              
              
              
              $
              543,311**Liabilities
                  and Stockholders’ Equity:**Interest-bearing
                  liabilities:Demand
                  deposit accounts
              
              $
              52,810
              
              $
              917
              
              
              1.74
              %
              $
              51,495
              
              $
              662
              
              
              1.29
              %
              $
              36,798
              
              $
              211
              
              
              0.57
              %Money
                  market deposit accounts
              
              
              126,247
              
              
              4,909
              
              
              3.89
              
              
              109,553
              
              
              4,187
              
              
              3.82
              
              
              78,092
              
              
              1,791
              
              
              2.29Savings
                  accounts
              
              
              14,093
              
              
              82
              
              
              0.58
              
              
              19,569
              
              
              150
              
              
              0.77
              
              
              26,219
              
              
              159
              
              
              0.61Certificates
                  of deposit
              
              
              342,259
              
              
              16,407
              
              
              4.79
              
              
              320,008
              
              
              13,104
              
              
              4.09
              
              
              231,000
              
              
              6,816
              
              
              2.95Borrowed
                  funds
              
              
              82,717
              
              
              4,185
              
              
              5.06
              
              
              86,183
              
              
              4,176
              
              
              4.85
              
              
              66,199
              
              
              2,492
              
              
              3.76Total
                  interest-bearing liabilities
              
              
              618,126
              
              
              26,500
              
              
              4.29
              
              
              586,808
              
              
              22,279
              
              
              3.80
              
              
              438,308
              
              
              11,469
              
              
              2.62Noninterest-bearing
                  deposits
              
              
              39,893
              
              
              
              
              
              
              
              
              35,310
              
              
              
              
              
              
              
              
              23,218Noninterest-bearing
                  liabilities
              
              
              10,282
              
              
              
              
              
              
              
              
              9,781
              
              
              
              
              
              
              
              
              7,423Total
                  liabilities
              
              
              668,301
              
              
              
              
              
              
              
              
              631,899
              
              
              
              
              
              
              
              
              468,949Stockholders’
                  equity
              
              
              84,784
              
              
              
              
              
              
              
              
              85,035
              
              
              
              
              
              
              
              
              74,362Total
                  liabilities and equity
              
              $
              753,085
              
              
              
              
              
              
              
              $
              716,934
              
              
              
              
              
              
              
              $
              543,311Net
                  interest income(2)
              
              
              
              
              $
              20,792
              
              
              
              
              
              
              
              $
              20,831
              
              
              
              
              
              
              
              $
              15,634Interest
                  rate spread(3)
              
              
              
              
              
              
              
              
              2.84
              %
              
              
              
              
              
              
              
              3.10
              %
              
              
              
              
              
              
              
              3.03
              %Net
                  interest margin(4)
              
              
              
              
              
              
              
              
              3.14
              %
              
              
              
              
              
              
              
              3.33
              %
              
              
              
              
              
              
              
              3.26
              %Ratio
                  of average interest-earning assets to avg. int.-bearing
                  liabilities
              
              
              
              
              
              107.26
              %
              
              
              
              
              
              
              
              106.53
              %
              
              
              
              
              109.40
              %





(1)
            Average
                loan balances include nonaccrual
                loans.


(2)
            Yields
                and interest income on tax-exempt investments have been adjusted
                on a tax
                equivalent basis using 34% for 2007, 2006, and
                2005.


(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
                average
                interest-earning assets.





25





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 Ended****December
                  31, 2007 vs. December 31, 2006**
              
              **December
                  31, 2006 vs. December 31, 2005****Increase
                  (Decrease) Due to**
              
              **Increase
                  (Decrease) Due to****(Dollars
                  in Thousands)**
              
              **Volume**
              
              **Rate**
              
              **Net**
              
              **Volume**
              
              **Rate**
              
              **Net**Interest
                  income:Loans
                  receivable
              
              $
              2,584
              
              $
              647
              
              $
              3,231
              
              $
              10,489
              
              $
              4,831
              
              $
              15,320Interest-bearing
                  bank deposits
              
              
              (347
              )
              
              (45
              )
              
              (392
              )
              
              133
              
              
              243
              
              
              375Investment
                  securities
              
              
              551
              
              
              488
              
              
              1,039
              
              
              224
              
              
              205
              
              
              429Mortgage-backed
                  securities
              
              
              2
              
              
              302
              
              
              304
              
              
              (432
              )
              
              314
              
              
              (118
              )Total
                  interest income
              
              
              2,790
              
              
              1,392
              
              
              4,182
              
              
              10,414
              
              
              5,593
              
              
              16,007Interest
                  expense:Deposits
              
              
              1,593
              
              
              2,619
              
              
              4,212
              
              
              4,109
              
              
              5,017
              
              
              9,126Borrowed
                  funds
              
              
              (92
              )
              
              101
              
              
              9
              
              
              863
              
              
              821
              
              
              1,684Total
                  interest expense
              
              
              1,501
              
              
              2,720
              
              
              4,221
              
              
              4,972
              
              
              5,838
              
              
              10,810Net
                  interest income
              
              $
              1,289
              
              $
              (1,328
              )
              $
              (39
              )
              $
              5,442
              
              $
              (245
              )
              $
              5,197




**Loans**





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.





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.





26





**Loan
      Portfolio**


**December
                  31, 2007**
              
              **December
                  31, 2006**
              
              **December
                  31, 2005****Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**(Dollars
                  in Thousands)Real
                  estate loans:One-to-four
                  family residential
              
              $
              78,572
              
              
              14.03
              %
              $
              83,265
              
              
              16.16
              %
              $
              98,635
              
              
              20.83
              %Multifamily
                  residential
              
              
              19,717
              
              
              3.52
              
              
              21,726
              
              
              4.22
              
              
              24,594
              
              
              5.19Construction
              
              
              90,949
              
              
              16.24
              
              
              76,505
              
              
              14.85
              
              
              62,687
              
              
              13.24Nonresidential
              
              
              254,782
              
              
              45.50
              
              
              231,265
              
              
              44.89
              
              
              185,319
              
              
              39.13Total
                  real estate loans
              
              
              444,020
              
              
              79.29
              
              
              412,761
              
              
              80.12
              
              
              371,235
              
              
              78.39Commercial
                  business loans
              
              
              33,583
              
              
              6.00
              
              
              32,202
              
              
              6.25
              
              
              30,128
              
              
              6.36Consumer
                  loans
              
              
              82,363
              
              
              14.71
              
              
              70,209
              
              
              13.63
              
              
              72,237
              
              
              15.25Total
                  gross loans
              
              
              559,966
              
              
              100.00
              %
              
              515,172
              
              
              100.00
              %
              
              473,600
              
              
              100.00
              %Less:Deferred
                  loan fees (costs), net
              
              
              10
              
              
              
              
              
              (230
              )
              
              
              
              
              264Allowance
                  for loan losses
              
              
              6,144
              
              
              
              
              
              5,764
              
              
              
              
              
              5,104Total
                  loans, net
              
              $
              553,812
              
              
              
              
              $
              509,638
              
              
              
              
              $
              468,232
  **December
                  31, 2004**
              
              **December
                  31, 2003****Amount**
              
              **Percent**
              
              **Amount**
              
              **Percent**(Dollars
                  in Thousands)Real
                  estate loans:One-to-four
                  family residential
              
              $
              91,714
              
              
              28.92
              %
              $
              102,751
              
              
              34.48
              %Multifamily
                  residential
              
              
              10,632
              
              
              3.35
              
              
              11,987
              
              
              4.02Construction
              
              
              25,033
              
              
              7.89
              
              
              8,913
              
              
              2.99Nonresidential
              
              
              114,551
              
              
              36.12
              
              
              94,357
              
              
              31.66Total
                  real estate loans
              
              
              241,930
              
              
              76.28
              
              
              218,008
              
              
              73.15Commercial
                  business loans
              
              
              14,002
              
              
              4.41
              
              
              14,001
              
              
              4.70Consumer
                  loans
              
              
              61,245
              
              
              19.31
              
              
              66,020
              
              
              22.15Total
                  gross loans
              
              
              317,177
              
              
              100.00
              %
              
              298,029
              
              
              100.00
              %Less:Deferred
                  loan fees, net
              
              
              21
              
              
              
              
              
              34Allowance
                  for loan losses
              
              
              3,029
              
              
              
              
              
              2,969Total
                  loans, net
              
              $
              314,127
              
              
              
              
              $
              295,026




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.





27




The
      following table represents the maturity distribution of the Company's loans
      by
      type, including fixed-rate loans, as of December 31, 2007. 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.





**Maturity
      Distribution of Loan Portfolio**


**One
                  year**
              
              **One
                  to**
              
              **Over
                  Five****or
                  Less**
              
              **Five
                  Years**
              
              **Years**
              
              **Total**(in
                  thousands)Real
                  Estate:One-to-four
                  family residential
              
              $
              2,148
              
              $
              4,986
              
              $
              71,438
              
              $
              78,572Multifamily
                  residential
              
              
              2,924
              
              
              7,520
              
              
              9,274
              
              
              19,718Construction
              
              
              58,944
              
              
              27,101
              
              
              4,904
              
              
              90,949Nonresidential
              
              
              73,753
              
              
              151,958
              
              
              29,070
              
              
              254,781Commercial
                  business
              
              
              17,315
              
              
              15,374
              
              
              894
              
              
              33,583Consumer
              
              
              2,083
              
              
              13,636
              
              
              66,644
              
              
              82,363Total
                  loans
              
              $
              157,167
              
              $
              220,575
              
              $
              182,224
              
              $
              559,966




The
      following table sets forth the dollar amount of all loans as of December 31,
      2007, 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
              
              $
              21,132
              
              $
              55,292
              
              $
              76,424Multifamily
                  residential
              
              
              5,925
              
              
              10,868
              
              
              16,793Construction
              
              
              20,114
              
              
              11,891
              
              
              32,005Nonresidential
              
              
              110,432
              
              
              70,597
              
              
              181,029Total
                  real estate loans
              
              
              157,603
              
              
              148,648
              
              
              306,251Commercial
                  business
              
              
              12,299
              
              
              3,969
              
              
              16,268Consumer
                  loans
              
              
              11,879
              
              
              68,401
              
              
              80,280Total
                  loans
              
              $
              181,781
              
              $
              221,018
              
              $
              402,799




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.





28




**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.





The
      following table sets forth information with respect to our nonperforming assets
      at the dates indicated. As of such dates, we had one restructured loan totaling
      $1.0 million within the meaning of SFAS No. 15 *“Accounting
      by Debtors and Creditors for Troubled Debt Restructuring.”* This
      loan
      is current and the customer has met all obligations under the modification
      agreement.





**Schedule
      of Nonperforming Assets**


**December
                  31,****2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**(Dollars
                  in thousands)Loans
                  accounted for on a nonaccrual basis:Real
                  estate loans:One-to-four
                  family residential
              
              $
              159
              
              $
              473
              
              $
              681
              
              $
              627
              
              $
              193Multifamily
                  residential
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Construction
              
              
              -
              
              
              -
              
              
              956
              
              
              -
              
              
              -Nonresidential
                  real estate
              
              
              520
              
              
              888
              
              
              397
              
              
              209
              
              
              20Commercial
                  business
              
              
              146
              
              
              78
              
              
              274
              
              
              30
              
              
              203Consumer
              
              
              221
              
              
              360
              
              
              243
              
              
              80
              
              
              113Total
                  nonaccrual loans
              
              
              1,046
              
              
              1,799
              
              
              2,551
              
              
              946
              
              
              529Accruing
                  loans which were contractually past due 90 days or more
              
              
              766
              
              
              1,212
              
              
              -
              
              
              -
              
              
              -Total
                  nonperforming loans
              
              
              1,812
              
              
              3,011
              
              
              2,551
              
              
              946
              
              
              529Real
                  estate owned
              
              
              529
              
              
              139
              
              
              1,157
              
              
              806
              
              
              145Total
                  nonperforming assets
              
              $
              2,341
              
              $
              3,150
              
              $
              3,708
              
              $
              1,752
              
              $
              674Nonperforming
                  loans to total loans
              
              
              0.32
              %
              
              0.58
              %
              
              0.54
              %
              
              0.30
              %
              
              0.18
              %Nonperforming
                  assets to total assets
              
              
              0.30
              %
              
              0.42
              %
              
              0.53
              %
              
              0.34
              %
              
              0.14
              %




**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, 2007, we had $529,000 in real estate acquired in settlement of
      loans. This balance is comprised of 13 single-family residences located in
      the
      Bank's normal lending area. These properties are in various stages of
      disposition.





29




**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. We had one restructured loan as of December 31,
      2007, totaling $1.0 million.





**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, 2007, we had $3.4 million of assets classified as 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, “ *Accounting
      by Creditors for Impairment of a Loan,”* management
      determined that impaired loans were not material as of December 31,
      2007.





As
      of
      December 31, 2006, we had $6.1 million in assets classified substandard and
      no
      assets classified as either doubtful or loss. The aggregate amount designated
      special mention as of December 31, 2006, was $9.6 million. Pursuant to SFAS
      No.
      114, management determined that impaired loans were not material as of December
      31, 2006.





**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
      collectibility.





At
      December 31, 2007, we had an allowance for loan losses of $6.1 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.





30





**Allowance
      of Loan Losses**


**At
                  and For the Year Ended December 31,****2007**
              
              **2006**
              
              **2005**
              
              **2004**
              
              **2003**(Dollars
                  in Thousands)Allowance
                  at beginning of period
              
              $
              5,764
              
              $
              5,104
              
              $
              3,029
              
              $
              2,969
              
              $
              2,995Charge-offs:One-to-four
                  family residential
              
              
              1
              
              
              -
              
              
              5
              
              
              14
              
              
              -Nonresidential
                  mortgage loans
              
              
              309
              
              
              -
              
              
              182
              
              
              174
              
              
              -Commercial
                  business loans
              
              
              861
              
              
              484
              
              
              158
              
              
              76
              
              
              -Consumer
                  loans
              
              
              83
              
              
              89
              
              
              76
              
              
              14
              
              
              94Total
                  charge-offs
              
              
              1,254
              
              
              573
              
              
              421
              
              
              278
              
              
              94Recoveries:One-to-four
                  family residential
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Nonresidential
                  mortgage loans
              
              
              -
              
              
              50
              
              
              5
              
              
              1
              
              
              -Commercial
                  business loans
              
              
              296
              
              
              8
              
              
              14
              
              
              4
              
              
              -Consumer
                  loans
              
              
              48
              
              
              10
              
              
              2
              
              
              3
              
              
              8Total
                  recoveries
              
              
              344
              
              
              68
              
              
              21
              
              
              8
              
              
              8Net
                  charge-offs
              
              
              910
              
              
              505
              
              
              400
              
              
              270
              
              
              86Provision
                  for loan losses
              
              
              1,290
              
              
              1,165
              
              
              985
              
              
              330
              
              
              60Allowance
                  acquired in acquisition
              
              
              -
              
              
              -
              
              
              1,490
              
              
              -
              
              
              -Allowance
                  at end of period
              
              $
              6,144
              
              $
              5,764
              
              $
              5,104
              
              $
              3,029
              
              $
              2,969Allowance
                  for loan losses to total gross loans
              
              
              1.10
              %
              
              1.12
              %
              
              1.08
              %
              
              0.95
              %
              
              1.00
              %Net
                  charge-offs to average loans
              
              
              0.17
              %
              
              0.10
              %
              
              0.12
              %
              
              0.09
              %
              
              0.03
              %




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.





31





**Allocation
      of Allowance for Loan Losses**


**December
                  31, 2007**
              
              **December
                  31, 2006**
              
              **December
                  31, 2005****%
                  of**
              
              
              
              **%
                  of**
              
              
              
              **%
                  of****Amount**
              
              **Total
                  Loans**
              
              **Amount**
              
              **Total
                  Loans**
              
              **Amount**
              
              **Total
                  Loans**(Dollars
                  in Thousands)Real
                  estate loans:One-to-four
                  family residential
              
              $
              250
              
              
              14.03
              %
              $
              300
              
              
              16.16
              %
              $
              300
              
              
              20.83
              %Multifamily
                  residential
              
              
              200
              
              
              3.52
              
              
              250
              
              
              4.22
              
              
              250
              
              
              5.19Construction
              
              
              900
              
              
              16.24
              
              
              750
              
              
              14.85
              
              
              500
              
              
              13.24Nonresidential
              
              
              2,494
              
              
              45.50
              
              
              2,264
              
              
              44.89
              
              
              1,854
              
              
              39.13Total
                  real estate loans
              
              
              3,844
              
              
              79.29
              
              
              3,564
              
              
              80.12
              
              
              2,904
              
              
              78.39Commercial
                  business
              
              
              1,000
              
              
              6.00
              
              
              1,000
              
              
              6.25
              
              
              1,000
              
              
              6.36Consumer
                  loans
              
              
              1,300
              
              
              14.71
              
              
              1,200
              
              
              13.63
              
              
              1,200
              
              
              15.25Total
                  allowance for loan losses
              
              $
              6,144
              
              
              100.00
              %
              $
              5,764
              
              
              100.00
              %
              $
              5,104
              
              
              100.00
              %
 
 **December
                  31, 2004**
              
              **December
                  31, 2003****%
                  of**
              
              
              
              **%
                  of****Amount**
              
              **Total
                  Loans**
              
              **Amount**
              
              **Total
                  Loans**(Dollars
                  in Thousands)Real
                  estate loans:One-to-four
                  family residential
              
              $
              250
              
              
              28.92
              %
              $
              399
              
              
              34.48
              %Multifamily
                  residential
              
              
              100
              
              
              3.35
              
              
              100
              
              
              4.02Construction
              
              
              300
              
              
              7.89
              
              
              150
              
              
              2.99Nonresidential
              
              
              609
              
              
              36.12
              
              
              550
              
              
              31.66Total
                  real estate loans
              
              
              1,259
              
              
              76.28
              
              
              1,199
              
              
              73.15Commercial
                  business
              
              
              600
              
              
              4.41
              
              
              600
              
              
              4.70Consumer
                  loans
              
              
              1,170
              
              
              19.31
              
              
              1,170
              
              
              22.15Total
                  allowance for loan losses
              
              $
              3,029
              
              
              100.00
              %
              $
              2,969
              
              
              100.00
              %


**Deposits**





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.





32





**Deposit
      Portfolio Composition**


**December
                  31, 2007**
              
              **December
                  31, 2006**
              
              **December
                  31, 2005****Average**
              
              
              
              **Average**
              
              
              
              **Average****Actual**
              
              **Interest**
              
              **Actual**
              
              **Interest**
              
              **Actual**
              
              **Interest****Category**
              
              **Balance**
              
              **Rate**
              
              **Balance**
              
              **Rate**
              
              **Balance**
              
              **Rate**(Dollars
                  in Thousands)Noninterest
                  bearing demand
              
              $
              43,571
              
              
              -
              %
              $
              37,762
              
              
              -
              %
              $
              35,226
              
              
              -
              %Interest
                  bearing demand
              
              
              58,410
              
              
              1.7
              
              
              52,778
              
              
              1.3
              
              
              50,263
              
              
              0.6Money
                  market deposit
              
              
              129,687
              
              
              3.9
              
              
              117,633
              
              
              3.8
              
              
              104,421
              
              
              2.3Savings
                  accounts
              
              
              12,038
              
              
              0.6
              
              
              16,027
              
              
              0.8
              
              
              23,654
              
              
              0.6Certificates
                  of deposit
              
              
              347,059
              
              
              4.8
              
              
              338,602
              
              
              4.1
              
              
              303,980
              
              
              3.0Total
                  Deposits
              
              $
              590,765
              
              
              3.9
              %
              $
              562,802
              
              
              3.4
              %
              $
              517,544
              
              
              2.3
              %




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, 2007.





**Maturities
      of Time Deposits over $100,000**




**Maturity
                  Period**
              
              **2007**(Dollars
                  in Thousands)Within
                  three months
              
              $
              31,826Over
                  three to six months
              
              
              47,154Over
                  six to twelve months
              
              
              36,494Over
                  twelve months
              
              
              16,712Total
                  time deposits over $100,000
              
              $
              132,186




The
      following table sets forth the amount of time deposits in the Bank categorized
      by rates as of December 31 st at the
      dates indicated.





**Time
      Deposit Interest Rate Composition**


**2007**
              
              **2006**
              
              **2005**(Dollars
                  in Thousands)Interest
                  RateLess
                  than 2.00%
              
              $
              599
              
              $
              940
              
              $
              4,7122.01-4.00%
              
              
              51,520
              
              
              69,406
              
              
              222,8804.01-6.00%
              
              
              294,940
              
              
              268,256
              
              
              76,3886.01-8.00%
              
              
              -
              
              
              -
              
              
              -$
              347,059
              
              $
              338,602
              
              $
              303,980




33





The
      following table sets forth the amount of time deposits in the Bank categorized
      by rates and maturities at December 31, 2007.





**Time
      Deposit Maturity Schedule**




**During
                  the Years Ended December 31,****2011****Interest
                  Rate**
              
              **2008**
              
              **2009**
              
              **2010**
              
              **or
                  Later**
              
              **Total**(Dollars
                  in Thousands)Less
                  than 2.0%
              
              $
              514
              
              $
              85
              
              $
              -
              
              $
              -
              
              $
              5992.01-4.0%
              
              
              41,471
              
              
              8,303
              
              
              1,180
              
              
              566
              
              
              51,5204.01-6.0%
              
              
              277,901
              
              
              9,687
              
              
              6,870
              
              
              482
              
              
              294,940Total
              
              $
              319,886
              
              $
              18,075
              
              $
              8,050
              
              $
              1,048
              
              $
              347,059


**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, 2007, 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,
      2007, 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, 2007, the Company had a capital-to-assets ratio
      of
      10.79%. As such, the Company fully expects to be able to meet future capital
      needs caused by growth and expansion as well as regulatory requirements. The
      Company plans to continue to repurchase its shares of common stock in the open
      market from time to time as market conditions warrant. During 2007, the Company
      repurchased 514,637 shares of common stock for a total purchase price of $6.4
      million.





**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. The
      Company has 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.





34




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 effect the Company's liquidity position. At December
      31,
      2007, the Company had loan commitments of $41.5 million, $4.2 million in
      undisbursed construction loan proceeds, and unused lines of credit of $148.3
      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, 2007. 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, 2007****One
                  Year**
              
              **One
                  to**
              
              **Over
                  Three**
              
              **Over
                  Five****Or
                  Less**
              
              **Three
                  Years**
              
              **to
                  Five Years**
              
              **Years**
              
              **Total**(Dollars
                  in Thousands)Borrowed
                  Funds
              
              $
              28,320
              
              $
              16,000
              
              $
              26,500
              
              $
              25,464
              
              $
              96,284Deposits
              
              
              563,619
              
              
              26,124
              
              
              1,022
              
              
              -
              
              
              590,765Lease
                  Obligations
              
              
              440
              
              
              671
              
              
              372
              
              
              -
              
              
              1,483Total
              
              $
              592,379
              
              $
              42,795
              
              $
              27,894
              
              $
              25,464
              
              $
              688,532




**Management
      of Market Risks**





Market
      risk reflects the risk of economic loss resulting from adverse changes in market
      price and interest risks. 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".





35




**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.





The
      Office of Thrift Supervision 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, 2007, 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
                  Theoretical****and
                  Sustained**
              
              **Net
                  Interest Income**
              
              **Net
                  Portfolio Value****Changes
                  in Interest Rates**
              
              **Amount**
              
              **%
                  Change**
              
              **Amount**
              
              **%
                  Change**(Dollars
                  in Thousands)300basis
                  point rise
              
              $
              22,699
              
              
              2.4
              %
              $
              90,154
              
              
              -13.7
              %200basis
                  point rise
              
              
              22,612
              
              
              2.0
              %
              
              95,119
              
              
              -9.0
              %100basis
                  point rise
              
              
              22,438
              
              
              1.3
              %
              
              100,181
              
              
              -4.1
              %No
                  change
              
              
              20,160
              
              
              -
              %
              
              104,476
              
              
              -
              %100basis
                  point decline
              
              
              22,207
              
              
              0.2
              %
              
              107,273
              
              
              2.7
              %200basis
                  point decline
              
              
              22,042
              
              
              -0.5
              %
              
              107,638
              
              
              3.0
              %300basis
                  point decline
              
              
              21,714
              
              
              -2.1
              %
              
              110,103
              
              
              5.4
              %


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.





36





**Quarterly
      Financial Data** **(unaudited)**


**First
                  Quarter**
              
              **Second
                  Quarter**
              
              **Third
                  Quarter**
              
              **Fourth
                  Quarter**(in
                  Thousands, Except per Share Data)**2007**Interest
                  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
  **2006**Interest
                  income
              
              $
              9,866
              
              $
              10,482
              
              $
              11,125
              
              $
              11,446Interest
                  expense
              
              
              4,767
              
              
              5,268
              
              
              5,923
              
              
              6,321Net
                  interest income
              
              
              5,099
              
              
              5,214
              
              
              5,202
              
              
              5,125Provision
                  for loan losses
              
              
              285
              
              
              280
              
              
              300
              
              
              300Net
                  int. income after provision for loan losses .
              
              
              4,814
              
              
              4,934
              
              
              4,902
              
              
              4,825Noninterest
                  income
              
              
              1,414
              
              
              1,369
              
              
              1,643
              
              
              1,715Noninterest
                  expense
              
              
              4,545
              
              
              4,282
              
              
              4,388
              
              
              4,329Income
                  before income taxes
              
              
              1,683
              
              
              2,021
              
              
              2,157
              
              
              2,211Income
                  taxes
              
              
              496
              
              
              674
              
              
              719
              
              
              728Net
                  income
              
              $
              1,187
              
              $
              1,347
              
              $
              1,438
              
              $
              1,483Per
                  share data:Net
                  income:Basic
              
              $
              0.15
              
              $
              0.17
              
              $
              0.18
              
              $
              0.19Diluted
              
              
              0.15
              
              
              0.17
              
              
              0.18
              
              
              0.18Cash
                  dividends declared
              
              
              0.075
              
              
              0.075
              
              
              0.075
              
              
              0.075Common
                  stock price:High
              
              
              13.35
              
              
              12.80
              
              
              13.86
              
              
              13.28Low
              
              
              12.35
              
              
              11.94
              
              
              12.25
              
              
              12.57


37
  **ITEM
                    7A.**
                  **Quantitative
                      and Qualitative Disclosures About Market
                      Risk**
 
 Information
            responsive to this item in contained in Item 7. above under the captions
            and
            "Capital Adequacy and Resources", “Liquidity” and "Management of Market
            Risk".
 
 38
 
 **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,
            2007 and
            2006, 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, 2007. These 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
            financial
            statements are free of material misstatement. An audit includes examining,
            on a
            test basis, evidence supporting the amounts and disclosures in the 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, 2007 and 2006, and the
            results
            of their operations and their cash flows for each of the years in the
            three-year
            period ended December 31, 2007, in conformity with accounting principles
            generally accepted in the United States of America.
 
 We
            have
            also audited, in accordance with the standards of the Public Company
            Accounting
            Oversight Board (United States), the effectiveness of Citizens South
            Banking
            Corporation’s internal control over financial reporting as of December 31, 2007,
            based on criteria established in *Internal
            Control-Integrated Framework* issued
            by the Committee of Sponsoring Organizations of the Treadway Commission
            (COSO)
            and our report dated March 14, 2008, expressed an unqualified opinion
            thereon.
 
 /s/
            Cherry, Bekaert & Holland, L.L.P.
 
 Gastonia,
            North Carolina
 March
            14,
            2008
 
 39
 **CITIZENS
              SOUTH BANKING CORPORATION**
 
 Consolidated
              Statements of Financial Condition
 
 **December
                        31,****2007**
                    
                    **2006****Assets**Cash
                        and due from banks
                    
                    $
                    14,285,431
                    
                    $
                    17,581,168Interest-earning
                        bank balances
                    
                    
                    15,454,043
                    
                    
                    8,639,809Cash
                        and cash equivalents
                    
                    
                    29,739,474
                    
                    
                    26,220,977Investment
                        securities available-for-sale
                    
                    
                    46,518,568
                    
                    
                    65,326,045Mortgage-backed
                        and related securities available-for-sale
                    
                    
                    69,892,914
                    
                    
                    60,691,351Loans,
                        net of deferred fees
                    
                    
                    559,955,975
                    
                    
                    515,401,738Allowance
                        for loan losses
                    
                    
                    (6,144,119
                    )
                    
                    (5,763,923
                    )Loans,
                        net
                    
                    
                    553,811,856
                    
                    
                    509,637,815Other
                        real estate owned
                    
                    
                    528,871
                    
                    
                    138,785Premises
                        and equipment, net
                    
                    
                    17,964,910
                    
                    
                    18,286,967Accrued
                        interest receivable
                    
                    
                    3,254,416
                    
                    
                    3,235,733Federal
                        Home Loan Bank stock
                    
                    
                    4,235,700
                    
                    
                    3,581,000Intangible
                        assets
                    
                    
                    31,037,233
                    
                    
                    31,666,233Bank
                        owned life insurance
                    
                    
                    16,099,371
                    
                    
                    15,526,615Other
                        assets
                    
                    
                    6,056,953
                    
                    
                    9,058,516Total
                        assets
                    
                    $
                    779,140,266
                    
                    $
                    743,370,037**Liabilities
                        and Stockholders' Equity**Deposits
                    
                    $
                    590,764,822
                    
                    $
                    562,801,771Borrowed
                        money
                    
                    
                    70,465,000
                    
                    
                    63,485,000Subordinated
                        debt
                    
                    
                    15,464,000
                    
                    
                    15,464,000Retail
                        repurchase agreements
                    
                    
                    10,355,320
                    
                    
                    7,015,488Deferred
                        compensation
                    
                    
                    5,388,586
                    
                    
                    5,723,439Other
                        liabilities
                    
                    
                    2,669,316
                    
                    
                    2,919,104Total
                        liabilities
                    
                    
                    695,107,044
                    
                    
                    657,408,802Commitments
                        and contingenciesStockholders'
                        EquityPreferred
                        stock, 10,000,000 shares authorized, none issued
                    
                    
                    -
                    
                    
                    -Common
                        stock, $0.01 par value, 20,000,000 shares authorized in 2007
                        and 2006,
                        9,062,727 shares issued in 2007 and 2006, and 7,610,017 shares
                        outstanding
                        in 2007 and 8,111,659 shares outstanding in 2006
                    
                    
                    90,628
                    
                    
                    90,628Additional
                        paid-in-capital
                    
                    
                    67,718,714
                    
                    
                    67,439,060Unallocated
                        common stock held by Employee Stock Ownership Plan
                    
                    
                    (1,247,345
                    )
                    
                    (1,430,189
                    )Retained
                        earnings, substantially restricted
                    
                    
                    36,028,442
                    
                    
                    33,031,512Accumulated
                        unrealized loss on securities available-for-sale, net of
                        tax
                    
                    
                    (343,491
                    )
                    
                    (991,084
                    )Treasury
                        stock of 1,452,710 shares at December 31, 2007, and 951,068
                        shares at
                        December 31, 2006, at cost
                    
                    
                    (18,213,726
                    )
                    
                    (12,178,692
                    )Total
                        stockholders' equity
                    
                    
                    84,033,222
                    
                    
                    85,961,235Total
                        liabilities and stockholders' equity
                    
                    $
                    779,140,266
                    
                    $
                    743,370,037
 
 See
              notes
              to consolidated financial statements.
 40
 **CITIZENS
              SOUTH BANKING CORPORATION**
 
 Consolidated
              Statements of Income
 
 **Year
                        Ended**
                    
                    **Year
                        Ended**
                    
                    **Year
                        Ended****December
                        31,**
                    
                    **December
                        31,**
                    
                    **December
                        31,****2007**
                    
                    **2006**
                    
                    **2005****Interest
                        income**Loans
                    
                    $
                    40,679,196
                    
                    $
                    37,447,545
                    
                    $
                    22,128,174Interest-bearing
                        bank deposits
                    
                    
                    446,743
                    
                    
                    838,140
                    
                    
                    462,508Investment
                        securities
                    
                    
                    2,669,784
                    
                    
                    1,996,698
                    
                    
                    1,603,325Mortgage-backed
                        and related securities
                    
                    
                    2,939,447
                    
                    
                    2,636,696
                    
                    
                    2,754,091Total
                        interest income
                    
                    
                    46,735,170
                    
                    
                    42,919,079
                    
                    
                    26,948,098**Interest
                        expense**Deposits
                    
                    
                    22,314,968
                    
                    
                    18,103,014
                    
                    
                    8,976,879Borrowed
                        funds
                    
                    
                    4,185,148
                    
                    
                    4,176,204
                    
                    
                    2,492,434Total
                        interest expense
                    
                    
                    26,500,116
                    
                    
                    22,279,218
                    
                    
                    11,469,313Net
                        interest income
                    
                    
                    20,235,054
                    
                    
                    20,639,861
                    
                    
                    15,478,785**Provision
                        for loan losses**
                    
                    
                    1,290,000
                    
                    
                    1,165,000
                    
                    
                    985,000Net
                        interest income after provision for loan losses
                    
                    
                    18,945,054
                    
                    
                    19,474,861
                    
                    
                    14,493,785**Noninterest
                        income**Fee
                        income on deposit accounts
                    
                    
                    2,722,037
                    
                    
                    2,855,419
                    
                    
                    2,486,197Fee
                        income on mortgage banking activities
                    
                    
                    990,364
                    
                    
                    638,080
                    
                    
                    276,252Fee
                        income on lending activities
                    
                    
                    483,983
                    
                    
                    644,662
                    
                    
                    297,106Net
                        gain (loss) on sale of securities
                    
                    
                    (74,422
                    )
                    
                    (41,350
                    )
                    
                    16,688Net
                        gain on sale of other assets
                    
                    
                    397,588
                    
                    
                    110,523
                    
                    
                    45,131Commissions
                        on sales of financial products
                    
                    
                    289,430
                    
                    
                    253,841
                    
                    
                    159,180Dividends
                        on FHLB stock
                    
                    
                    211,560
                    
                    
                    221,413
                    
                    
                    155,310Fair
                        market adjustment on deferred compensation assets
                    
                    
                    121,815
                    
                    
                    206,987
                    
                    
                    83,251Increase
                        in value of bank owned life insurance
                    
                    
                    769,467
                    
                    
                    762,213
                    
                    
                    614,452Life
                        insurance proceeds, net
                    
                    
                    112,063
                    
                    
                    -
                    
                    
                    -Other
                        income
                    
                    
                    538,537
                    
                    
                    489,026
                    
                    
                    307,718Total
                        noninterest income
                    
                    
                    6,562,422
                    
                    
                    6,140,814
                    
                    
                    4,441,285**Noninterest
                        expense**Compensation
                        and benefits
                    
                    
                    9,728,565
                    
                    
                    9,393,723
                    
                    
                    7,271,073Occupancy
                    
                    
                    2,648,284
                    
                    
                    2,614,131
                    
                    
                    2,100,862Office
                        supplies expense
                    
                    
                    195,016
                    
                    
                    258,434
                    
                    
                    241,827Advertising
                    
                    
                    521,692
                    
                    
                    492,133
                    
                    
                    287,288Professional
                        services
                    
                    
                    543,881
                    
                    
                    550,191
                    
                    
                    540,281Telephone
                        and communications
                    
                    
                    258,885
                    
                    
                    350,023
                    
                    
                    284,116Data
                        processing
                    
                    
                    413,288
                    
                    
                    347,043
                    
                    
                    352,709Deposit
                        insurance
                    
                    
                    66,147
                    
                    
                    65,407
                    
                    
                    53,932Amortization
                        of intangible assets
                    
                    
                    629,000
                    
                    
                    734,000
                    
                    
                    408,907Impairment
                        on investment securities
                    
                    
                    161,910
                    
                    
                    -
                    
                    
                    -Merger
                        and conversion expense
                    
                    
                    -
                    
                    
                    56,628
                    
                    
                    383,809Other
                        expense
                    
                    
                    2,728,829
                    
                    
                    2,681,965
                    
                    
                    2,414,745Total
                        noninterest expense
                    
                    
                    17,895,497
                    
                    
                    17,543,678
                    
                    
                    14,339,549**Income
                        before income taxes**
                    
                    
                    7,611,979
                    
                    
                    8,071,997
                    
                    
                    4,595,521**Provision
                        for income taxes**
                    
                    
                    1,947,269
                    
                    
                    2,617,120
                    
                    
                    1,322,812**Net
                        income**
                    
                    $
                    5,664,710
                    
                    $
                    5,454,877
                    
                    $
                    3,272,709**Earnings
                        per share**Basic
                        earnings per share
                    
                    $
                    0.74
                    
                    $
                    0.68
                    
                    $
                    0.45Diluted
                        earnings per share
                    
                    $
                    0.73
                    
                    $
                    0.67
                    
                    $
                    0.45
 
 See
              notes
              to consolidated financial statements.
  41
 **CITIZENS
              SOUTH BANKING CORPORATION**
 
 Consolidated
              Statements of Comprehensive Income
 
 **Year
                        Ended**
                    
                    **Year
                        Ended**
                    
                    **Year
                        Ended****December
                        31,**
                    
                    **December
                        31,**
                    
                    **December
                        31,****2007**
                    
                    **2006**
                    
                    **2005**Net
                        income
                    
                    $
                    5,664,710
                    
                    $
                    5,454,877
                    
                    $
                    3,272,709**Items
                        of other comprehensive income (loss):**Items
                        of other comprehensive income (loss), before taxUnrealized
                        holding losses arising during period
                    
                    
                    979,432
                    
                    
                    919,792
                    
                    
                    (1,869,781
                    )Reclassification
                        adjustment for securities (gains) losses included in net
                        income
                    
                    
                    74,422
                    
                    
                    41,350
                    
                    
                    (16,688
                    )Other
                        comprehensive income (loss), before tax
                    
                    
                    1,053,854
                    
                    
                    961,142
                    
                    
                    (1,886,469
                    )Change
                        in deferred income taxes related to changesChange
                        in deferred income taxes related to changes in unrealized
                        gains or losses
                        on securities available for sale
                    
                    
                    (406,261
                    )
                    
                    (385,192
                    )
                    
                    737,987Items
                        of other comprehensive income (loss)
                    
                    
                    647,593
                    
                    
                    575,950
                    
                    
                    (1,148,482
                    )Comprehensive
                        income
                    
                    $
                    6,312,303
                    
                    $
                    6,030,827
                    
                    $
                    2,124,227
 
 See
              notes
              to consolidated financial statements.
 42
 **CITIZENS
              SOUTH BANKING CORPORATION**
 
 Consolidated
              Statements of Changes in Stockholders' Equity
 
 Unallocated
                    
                    
                    
                    AccumulatedCommon
                    
                    Retained
                    
                    UnrealizedAdditional
                    
                    Stock
                    
                    Earnings
                    
                    Gains
                    
                    
                    
                    TotalPreferred
                    
                    Common
                    
                    Paid-In
                    
                    Held
                        by
                    
                    Substantially
                    
                    (Losses),
                    
                    Treasury
                    
                    Stockholders'Stock
                    
                    Stock
                    
                    Capital
                    
                    ESOP
                    
                    Restricted
                    
                    net
                        of tax
                    
                    Stock
                    
                    Equity**Balance,
                        January 1, 2005**
                    
                    
                    -
                    
                    
                    90,628
                    
                    
                    66,682,322
                    
                    
                    (1,795,877
                    )
                    
                    29,765,725
                    
                    
                    (418,552
                    )
                    
                    (21,929,989
                    )
                    
                    72,394,257Comprehensive
                        results:Net
                        income
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    3,272,709
                    
                    
                    -
                    
                    
                    -
                    
                    
                    3,272,709Other
                        comprehensive results, net of tax
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,148,482
                    )
                    
                    -
                    
                    
                    (1,148,482
                    )Allocation
                        from shares purchased with loan to ESOP
                    
                    
                    -
                    
                    
                    -
                    
                    
                    87,020
                    
                    
                    182,844
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    269,864Repurchase
                        of common stock
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (5,654,999
                    )
                    
                    (5,654,999
                    )Vesting
                        of Recognition and Retention Plan
                    
                    
                    -
                    
                    
                    -
                    
                    
                    279,816
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    279,816Exercise
                        of options
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (189,295
                    )
                    
                    -
                    
                    
                    329,964
                    
                    
                    140,669Issuance
                        of treasury stock (100 shares)
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (470,678
                    )
                    
                    -
                    
                    
                    17,242,300
                    
                    
                    16,771,622Cash
                        dividends declared on common stock
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (2,067,808
                    )
                    
                    -
                    
                    
                    -
                    
                    
                    (2,067,808
                    )**Balance,
                        December 31, 2005**
                    
                    
                    -
                    
                    
                    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
                    )
                    
                    84,033,222
 
 See
              notes
              to consolidated financial statements.
  43
 **CITIZENS
              SOUTH BANKING CORPORATION**
 
 Consolidated
              Statements of Cash Flows
 
 **Year
                        Ended**
                    
                    **Year
                        Ended**
                    
                    **Year
                        Ended****December
                        31,**
                    
                    **December
                        31,**
                    
                    **December
                        31,****2007**
                    
                    **2006**
                    
                    **2005****Operating
                        Activities**Net
                        Income
                    
                    $
                    5,664,710
                    
                    $
                    5,454,877
                    
                    $
                    3,272,709Adjustments
                        to reconcile net income to net cash provided by operating
                        activitiesProvision
                        for loan losses
                    
                    
                    1,290,000
                    
                    
                    1,165,000
                    
                    
                    985,000Depreciation
                    
                    
                    1,159,739
                    
                    
                    1,330,879
                    
                    
                    1,221,098Impairment
                        on investment securities
                    
                    
                    161,910
                    
                    
                    -
                    
                    
                    -Deferred
                        income tax (benefit)
                    
                    
                    (475,628
                    )
                    
                    (408,355
                    )
                    
                    224,212(Gain)
                        loss on sale of investments available-for-sale
                    
                    
                    74,422
                    
                    
                    41,350
                    
                    
                    (16,688
                    )Gain
                        on sale of other assets
                    
                    
                    (397,588
                    )
                    
                    (110,524
                    )
                    
                    (45,131
                    )Deferred
                        loan origination fees
                    
                    
                    87,765
                    
                    
                    (410,116
                    )
                    
                    243,035Amortization
                        of intangible assets
                    
                    
                    629,000
                    
                    
                    734,000
                    
                    
                    408,907Allocation
                        of shares to the ESOP
                    
                    
                    260,688
                    
                    
                    267,736
                    
                    
                    269,864Stock
                        option expense
                    
                    
                    27,967
                    
                    
                    25,194
                    
                    
                    -Vesting
                        of shares issued for the RRP Plan
                    
                    
                    302,144
                    
                    
                    279,816
                    
                    
                    279,816(Increase)
                        decrease in interest receivable
                    
                    
                    (18,683
                    )
                    
                    (697,037
                    )
                    
                    (249,399
                    )Net
                        (increase) decrease in other operating assets
                    
                    
                    1,183,265
                    
                    
                    (1,063,582
                    )
                    
                    3,971,815Net
                        cash provided by operating activities
                    
                    
                    9,949,711
                    
                    
                    6,609,238
                    
                    
                    10,565,238**Investing
                        Activities**Acquisition
                        of Trinity Bank, net of cash acquired
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (16,771,138
                    )Net
                        increase in loans made to customers
                    
                    
                    (45,748,924
                    )
                    
                    (42,160,673
                    )
                    
                    (43,043,715
                    )Proceeds
                        from the sale of investment securities
                    
                    
                    8,675,120
                    
                    
                    98,300
                    
                    
                    9,391,794Proceeds
                        from the sale of mortgage-backed and related securities
                    
                    
                    8,299,293
                    
                    
                    2,236,956
                    
                    
                    30,325,830Proceeds
                        from the sale of loans
                    
                    
                    201,820
                    
                    
                    -
                    
                    
                    -Proceeds
                        from the sale of premises and equipment
                    
                    
                    800,792
                    
                    
                    647,813
                    
                    
                    191,064Proceeds
                        from sale of REO
                    
                    
                    333,788
                    
                    
                    914,074
                    
                    
                    517,393Maturities
                        and prepayments of investment securities
                    
                    
                    19,518,392
                    
                    
                    13,848,457
                    
                    
                    5,066,025Maturities
                        and prepayments of mortgage-backed and related securities
                    
                    
                    12,435,674
                    
                    
                    14,967,504
                    
                    
                    20,232,254Purchases
                        of investment securities
                    
                    
                    (9,829,278
                    )
                    
                    (25,643,486
                    )
                    
                    (10,623,066
                    )Purchases
                        of mortgage-backed and related securities
                    
                    
                    (28,675,766
                    )
                    
                    (6,940,190
                    )
                    
                    (8,788,599
                    )Purchases
                        (sales) of FHLB stock
                    
                    
                    (654,700
                    )
                    
                    502,700
                    
                    
                    331,500Purchases
                        of premises and equipment
                    
                    
                    (1,228,756
                    )
                    
                    (232,149
                    )
                    
                    (1,375,950
                    )Net
                        cash used in investing activities
                    
                    
                    (35,872,545
                    )
                    
                    (41,760,694
                    )
                    
                    (14,546,608
                    )**Financing
                        Activities**Net
                        increase in deposits
                    
                    
                    27,963,051
                    
                    
                    45,257,970
                    
                    
                    6,534,989Dividends
                        to stockholders
                    
                    
                    (2,468,772
                    )
                    
                    (2,411,060
                    )
                    
                    (2,067,808
                    )Exercise
                        of options
                    
                    
                    83,991
                    
                    
                    135,793
                    
                    
                    140,669Repurchase
                        of common stock
                    
                    
                    (6,446,335
                    )
                    
                    (2,624,719
                    )
                    
                    (5,654,999
                    )Increase
                        (decrease) in borrowed money
                    
                    
                    10,319,832
                    
                    
                    (9,051,563
                    )
                    
                    18,981,000Increase
                        in repurchase agreements
                    
                    
                    -
                    
                    
                    3,445,221
                    
                    
                    1,171,053Increase
                        (decrease) in advances from borrowers for insurance and
                        taxes
                    
                    
                    (10,436
                    )
                    
                    (32,647
                    )
                    
                    (60,357
                    )Net
                        cash provided by financing activities
                    
                    
                    29,441,331
                    
                    
                    34,718,995
                    
                    
                    19,044,547Net
                        increase (decrease) in cash and cash equivalents
                    
                    
                    3,518,497
                    
                    
                    (432,461
                    )
                    
                    15,063,177Cash
                        and cash equivalents at the beginning of the year
                    
                    
                    26,220,977
                    
                    
                    26,653,438
                    
                    
                    11,590,261Cash
                        and cash equivalents at the end of the year
                    
                    $
                    29,739,474
                    
                    $
                    26,220,977
                    
                    $
                    26,653,438
 
 See
              notes
              to consolidated financial statements.
 44
  **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 14
            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, 2007,
            Citizens
            South Bank had 14 full-service branch offices in the North Carolina Counties
            of
            Gaston, Union, Rowan, and Iredell.
 
 *Basis
            of Presentation*  - The
            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
            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.
 
 *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.
  45
  *Investment
            securities*  - Investment securities are generally classified as “available for sale”
securities by management at the time of purchase. These securities are
            used to
            execute asset/liability management strategies and to manage liquidity.
            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.
            No
            securities have been classified as either “held to maturity securities” or
“trading securities.”
 
 *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 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
            collectibility of the principal balance of an impaired loan is in doubt,
            cash
            receipts are applied to principal.
 
 *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
            collectibility.
 
 *Concentrations
            of Credit Risk*  - The
            Company makes loans to individuals and small 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.
 
 46
 
 *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, 2007, 2006 and 2005 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 c ore
            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.
  47
 
 Prior
            to
            the adoption of SFAS 123(R), the Company applied the provisions of Accounting
            Principles Board (“APB”) Opinion No. 25 in accounting for the plans and
            accordingly, no compensation expense was recognized in connection with
            the
            granting of the stock options during those periods. In accordance with
            SFAS No.
            123, *Accounting
            for Stock-Based Compensation* ,
            the
            Company adopted the disclosure-only option and elected to apply the provisions
            of APB No. 25 for financial statement purposes. The Company recognized
            compensation expense for fixed awards with pro rata vesting on a straight-line
            basis. Had the compensation cost for the Company’s stock option plan been
            determined in accordance with the fair-value accounting provisions of
            SFAS No.
            123, net income, basic earnings per share and diluted earnings per share
            for the
            year ended December 31, 2005 would have been as follows:
  **2005**Net
                        income:As
                        reported
                    
                    $
                    3,272,709Deduct:
                        Stock based compensation
                    
                    
                    (206,991
                    )Pro
                        forma
                    
                    
                    3,065,718Basic
                        earnings per share:As
                        reported
                    
                    $
                    0.45Pro
                        forma
                    
                    
                    0.43Diluted
                        earnings per share:As
                        reported
                    
                    $
                    0.45Pro
                        forma
                    
                    
                    0.42
 
 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 2.0%, expected volatility of 30%,
            a
            risk-free interest rate of 4.0%, and expected lives of seven years for
            the
            options.
 
 *New
            Accounting Standards -*  In
            September 2006, the Financial Accounting Standards Board
            (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.
            157, “ *Fair
            Value Measurements* ”
(“SFAS
            No. 157”), which enhances existing guidance for measuring assets and
            liabilities using fair value and requires additional disclosure about
            the use of
            fair value for measurement. This Statement does not require any new fair
            value
            measurements. SFAS No. 157 is effective for the Company January 1, 2008.
            The
            Company is currently evaluating the impact of the adoption of SFAS No. 157
            on its financial position and results of operations, including the valuation
            methods and support for the assumptions that underlie the valuation.
 
 In
            February 2007, FASB issued SFAS No. 159, “ *The
            Fair Value Option for Financial Assets and Financial
            Liabilities* ”
(“SFAS
            No. 159”), which permits entities to choose and measure many financial
            instruments and certain other items at fair value. The
            objective of this Statement is to improve financial reporting by providing
            entities with the opportunity to mitigate volatility in reported earnings
            caused
            by measuring related assets and liabilities differently without having
            to apply
            complex hedge accounting provisions. This Statement is effective for
            fiscal
            years beginning after November 15, 2007, with early adoption permitted
            under certain circumstances. The Company has chosen not to early adopt
            the
            provisions of SFAS No. 159, so this Statement will be effective for the
            Company
            on January 1, 2008. The Company has evaluated this statement and does
            not
            believe it will have a material effect on the Company’s consolidated financial
            statements.
 
 48
  In
            September 2006, the Emerging Issues Task Force issued EITF Issue 06-4,
“ *Accounting
            for Deferred Compensation and Postretirement Benefit Aspects of Endorsement
            Split-Dollar Life Insurance Arrangements* ”
(“EITF
            Issue 06-4”). EITF Issue 06-4 requires that for endorsement split-dollar
            insurance arrangements that provide a benefit to an employee that extends
            to
            postretirement periods, an employer should recognize a liability for
            future
            benefits in accordance with SFAS No. 106 or APB No. 12 based on
            the substantive agreement of the employee. If the employee has effectively
            agreed to maintain a life insurance policy during postretirement periods,
            the
            costs of the life insurance policy during the postretirement periods
            should be
            accrued in accordance with either SFAS No. 106 or APB No. 12. If the
            employer has agreed to provide a death benefit, the employer should recognize
            a
            liability for the future death benefit in accordance with either SFAS
            No. 106 or APB No. 12. EITF Issue 06-4 is effective for fiscal years
            beginning after December 15, 2007. The Company is currently evaluating the
            impact of EITF Issue 06-4 on its financial position and results of
            operations.
 
 In
            June
            2007, the FASB ratified the consensus reached by the EITF on Issue No.
            06-11,
“Accounting for Income Tax Benefits of Dividends on Share-Based Payment
            Awards”
to provide guidance on how an entity should recognize the income tax
            benefit
            received on dividends that are paid to employees holding certain types
            of shares
            or options and are charged to retained earnings under Statement 123(R).
            This
            issue will be applied for the Company beginning January 1, 2008. The
            Company is currently evaluating the impact of EITF Issue 06-11 on its
            financial
            position and results of operations.
 
 **Note
            2 - Business Combination**
 
 On
            October 31, 2005, the Company consummated the merger of Trinity Bank
            (“Trinity”)
            into Citizens South Bank. Trinity was headquartered in Monroe, North
            Carolina,
            which is approximately 50 miles east of the Company’s headquarters. Accordingly,
            the results of operations of Trinity are included in the consolidated
            financial
            statements for the two-month period ended December 31, 2005. Trinity
            had three
            offices located in Union County, North Carolina, which had the fastest
            population growth of any county in North Carolina. The Company pursued
            the
            acquisition of Trinity in order to gain access to this high-growth market
            which
            complements the Company’s existing locations and to improve the Company’s
            efficiency ratio by adding an increased number of customer accounts to
            the
            Company’s existing operating structure.
 
 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 will be exchanged for Citizens
            South
            common stock. On October 31, 2005, Trinity shareholders received merger
            consideration of approximately 1,280,249 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, and
            resulted in goodwill of $23.0 million and a core deposit intangible of
            $2.3
            million. The core deposit intangible is being amortized over an eight-year
            life
            on an accelerated basis.
 
 In
            order
            to provide financing for the cash portion of the Trinity acquisition,
            on October
            28, 2005, the Company completed a private placement of an aggregate amount
            of
            $15.0 million in trust preferred securities, liquidation amount of $1,000
            per
            security (the “Preferred Securities”), through a newly formed Delaware statutory
            trust subsidiary, CSBC Statutory Trust I (the “Trust”). In connection with the
            issuance of the Preferred Securities, on October 28, 2005, the Company
            entered
            into an Indenture by and between the Company and Wilmington Trust Company,
            as
            trustee. The Preferred Securities mature on December 15, 2035, but may
            be
            redeemed beginning December 15, 2010, if the Company exercises its rights
            to
            redeem the Debentures. The Preferred Securities require quarterly interest
            payments to the holders of the Preferred Securities, initially at a fixed
            rate
            of 6.095% through December 2010, and thereafter at a variable rate of
            three-month LIBOR plus 1.57%, reset quarterly.
 
 49
 
 The
            following summarizes the unaudited results of operations as though the
            acquisition of Trinity Bank had occurred at January 1, 2005.
 **2005**Interest
                        income
                    
                    $
                    33,805,000Interest
                        expense
                    
                    
                    (14,480,000
                    )Net
                        interest income
                    
                    
                    19,325,000Provision
                        for loan losses
                    
                    
                    (1,000,000
                    )Net
                        interest income after provision
                    
                    
                    18,325,000Noninterest
                        income
                    
                    
                    5,175,000Noninterest
                        expense
                    
                    
                    (17,830,000
                    )Income
                        before income taxes
                    
                    
                    5,670,000Provision
                        for income taxes
                    
                    
                    (1,718,000
                    )Net
                        income
                    
                    $
                    3,952,000Basic
                        earnings per share
                    
                    $
                    0.55Diluted
                        earnings per share
                    
                    $
                    0.54
  **Note
            3 - Investment Securities**
 
 The
            aggregate book and 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, 2007 and 2006, were as follows:
 
 **December
                      31, 2007****Book**
                    **Value**
                  
                  **Unrealized**
                    **Gains**
                  
                  **Unrealized**
                    **Losses**
                  
                  **Fair**
                    **Value**Investment
                      Securities:U.S.governmentagency 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
  50
  **December
                      31, 2007****Book**
                    **Value**
                  
                  **Unrealized**
                    **Gains**
                  
                  **Unrealized**
                    **Losses**
                  
                  **Fair**
                    **Value**Mortgage-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
 
 
 **December
                      31, 2006****Book**
                    **Value**
                  
                  **Unrealized**
                    **Gains**
                  
                  **Unrealized**
                    **Losses**
                  
                  **Fair**
                    **Value**Investment
                      Securities:U.S.governmentagency bonds
                  
                  $
                  33,319,355
                  
                  $
                  2,590
                  
                  $
                  (320,911
                  )
                  $
                  33,001,034Municipal
                      bonds
                  
                  
                  28,298,006
                  
                  
                  132,897
                  
                  
                  (88,381
                  )
                  
                  28,342,522Corporate
                      bonds
                  
                  
                  1,500,000
                  
                  
                  -
                  
                  
                  (27,000
                  )
                  
                  1,473,000Trust
                      preferred securities
                  
                  
                  1,000,000
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,000,000Other
                      equity securities
                  
                  
                  1,469,840
                  
                  
                  122,967
                  
                  
                  (83,318
                  )
                  
                  1,509,489Total
                      investment securities
                  
                  $
                  65,587,201
                  
                  $
                  258,454
                  
                  $
                  (519,610
                  )
                  $
                  65,326,045
 
 
 **December
                      31, 2006****Book**
                    **Value**
                  
                  **Unrealized**
                    **Gains**
                  
                  **Unrealized**
                    **Losses**
                  
                  **Fair**
                    **Value**Mortgage-backed
                      and related securities:Fannie
                      Mae
                  
                  $
                  39,783,539
                  
                  $
                  5,580
                  
                  $
                  (933,030
                  )
                  $
                  38,856,089Freddie
                      Mac
                  
                  
                  21,273,371
                  
                  
                  966
                  
                  
                  (421,660
                  )
                  
                  20,852,677Ginnie
                      Mae
                  
                  
                  986,116
                  
                  
                  1,130
                  
                  
                  (4,661
                  )
                  
                  982,585Total
                      mortgage-backed andrelated
                      securities
                  
                  $
                  62,043,026
                  
                  $
                  7,676
                  
                  $
                  (1,359,351
                  )
                  $
                  60,691,351
 
 
 51
 
 The
            book
            value and estimated fair value of debt securities, available for sale
            at
            December 31, 2007, by contractual maturity, are shown below. Expected
            maturities
            will differ from contractual maturities because borrowers may have the
            right to
            call or prepay obligations with or without call or prepayment
            penalties.
 
 **December
                      31, 2007****Book**
                    **Value**
                  
                  **Fair**
                    **Value**Investment
                      Securities:Due
                      in one year or less
                  
                  $
                  4,449,605
                  
                  $
                  4,429,598Due
                      after one year****through
                      five years
                  
                  
                  10,479,115
                  
                  
                  10,510,209Due
                      after five years through ten years
                  
                  
                  8,573,364
                  
                  
                  8,582,268Due
                      after ten years
                  
                  
                  22,280,806
                  
                  
                  21,686,675Equities
                  
                  
                  1,211,258
                  
                  
                  1,309,818Total
                      investment securities
                  
                  $
                  46,994,148
                  
                  $
                  46,518,568Mortgage-backed
                      and related securities
                  
                  $
                  69,976,312
                  
                  $
                  69,892,914
 
 Gross
            realized gains on the sale of securities available for sale were $81,524,
            $92,964, and $48,589 for the years ended December 31, 2007, December
            31, 2006,
            and December 31, 2005, respectively. Gross realized losses on the sale
            of
            securities available for sale were $155,946, $134,314, and $31,901for
            the years
            ended December 31, 2007, December 31, 2006, and December 31, 2005, respectively.
            After-tax net gains on the sale of securities were ($45,732), ($25,409),
            and
            $10,255 for the years ended December 31, 2007, December 31, 2006, and
            December
            31, 2005, respectively.
 
 As
            of
            December 31, 2007, investment securities having a carrying amount of
            $36,810,929
            have been pledged as collateral to secure public deposits, $11,756,880
            have been
            pledged as collateral for retail repurchase agreements, $7,260,185 have
            been
            pledged as collateral for wholesale repurchase agreements, and $200,000
            have
            been pledged as collateral for Federal Reserve Bank Treasury Tax and
            Loan
            deposits.
 
 Interest
            earned from municipal securities, which is exempt from income taxes,
            for the
            past three years were $1,382,458, $516,358, and $441,102 for the years
            ending
            December 31, 2007, December 31, 2006, and December 31, 2005,
            respectively.
 
 52
 
 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,
            2007,
            and December 31, 2006, are as follows:
  **December
                      31,
                      2007****Less
                      than 12 months**
                  
                  **12
                      months or more**
                  
                  **Total****Fair**
                  
                  **Unrealized**
                  
                  **Fair**
                  
                  **Unrealized**
                  
                  **Fair**
                  
                  **Unrealized****Description
                      of Securities**
                  
                  **Value**
                  
                  **Loss**
                  
                  **Value**
                  
                  **Loss**
                  
                  **Value**
                  
                  **Loss**U.S.
                      govt. 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
                  )Federal
                      agency mortgage-backed
                      securities
                  
                  
                  2,994,589
                  
                  
                  (6,932
                  )
                  
                  28,737,077
                  
                  
                  (434,457
                  )
                  
                  31,731,666
                  
                  
                  (441,389
                  )Total
                      temporarilyimpaired
                      securities
                  
                  $
                  21,850,196
                  
                  $
                  (607,028
                  )
                  $
                  40,189,930
                  
                  $
                  (561,679
                  )
                  $
                  62,040,126
                  
                  $
                  (1,168,707
                  )
   **December
                      31,
                      2006****Less
                      than 12 months**
                  
                  **12
                      months or more**
                  
                  **Total****Fair**
                  
                  **Unrealized**
                  
                  **Fair**
                  
                  **Unrealized**
                  
                  **Fair**
                  
                  **Unrealized****Description
                      of Securities**
                  
                  **Value**
                  
                  **Loss**
                  
                  **Value**
                  
                  **Loss**
                  
                  **Value**
                  
                  **Loss**US
                      government agencies
                  
                  $
                  4,493,967
                  
                  $
                  (7,511
                  )
                  $
                  22,504,477
                  
                  $
                  (313,400
                  )
                  $
                  26,998,444
                  
                  $
                  (320,911
                  )Municipals
                  
                  
                  1,785,668
                  
                  
                  (7,403
                  )
                  
                  4,951,650
                  
                  
                  (80,978
                  )
                  
                  6,737,318
                  
                  
                  (88,381
                  )Corporate
                      bonds
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,473,000
                  
                  
                  (27,000
                  )
                  
                  1,473,000
                  
                  
                  (27,000
                  )Federal
                      agency mortgagebacked
                      securities
                  
                  
                  7,499,952
                  
                  
                  (13,544
                  )
                  
                  44,926,820
                  
                  
                  (1,345,807
                  )
                  
                  52,426,772
                  
                  
                  (1,359,351
                  )Subtotal
                      debt securities
                  
                  
                  13,779,587
                  
                  
                  (28,458
                  )
                  
                  73,855,947
                  
                  
                  (1,767,185
                  )
                  
                  87,635,534
                  
                  
                  (1,795,643
                  )Other
                      equity securities
                  
                  
                  222,168
                  
                  
                  (83,318
                  )
                  
                  -
                  
                  
                  -
                  
                  
                  222,168
                  
                  
                  (83,318
                  )Total
                      temporarilyimpaired
                      securities
                  
                  $
                  14,001,755
                  
                  $
                  (111,776
                  )
                  $
                  73,855,947
                  
                  $
                  (1,767,185
                  )
                  $
                  87,857,702
                  
                  $
                  (1,878,961
                  )
 
 Management
            considers all of the unrealized losses that have been outstanding for
            12 or more
            months to be temporary impairments since these impairments are primarily
            due to
            changes in interest rates. Management has the ability and intent to hold
            these
            securities until they are no longer considered to be impaired, which
            may be
            maturity.
 
 53
 
 **Note
            4 - Loans and Allowance for Loan Losses**
 
 The
            following is a summary of loans outstanding by category at December
            31:
 
 **2007**
                  
                  **2006**Real
                      estate:One-to-four
                      family residential
                  
                  $
                  78,572,380
                  
                  $
                  83,264,793Multi-family****residential
                  
                  
                  19,717,641
                  
                  
                  21,725,953Construction
                  
                  
                  90,948,598
                  
                  
                  76,505,202Nonresidential
                  
                  
                  254,781,774
                  
                  
                  231,264,961Commercial
                  
                  
                  33,582,788
                  
                  
                  32,201,870Consumer
                  
                  
                  82,362,726
                  
                  
                  70,209,136Gross
                      loans
                  
                  
                  559,965,907
                  
                  
                  515,171,915Less:Deferred
                      loan fees, net and other items
                  
                  
                  9,932
                  
                  
                  (229,823
                  )Allowance
                      for loan losses
                  
                  
                  6,144,119
                  
                  
                  5,763,923Net
                      loans
                  
                  $
                  553,811,856
                  
                  $
                  509,637,815
 
 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, 2007 and 2006 were
            immaterial.
 
 Changes
            in the allowance for loan losses for the years ended December 31, 2007,
            December
            31, 2006 and December 31, 2005 were as follows:
 
 **2007**
                  
                  **2006**
                  
                  **2005**Balance
                      at beginning of year
                  
                  $
                  5,763,923
                  
                  $
                  5,102,304
                  
                  $
                  3,029,108Provision
                      for loan losses
                  
                  
                  1,290,000
                  
                  
                  1,165,000
                  
                  
                  985,000Loans
                      charged off
                  
                  
                  (1,253,619
                  )
                  
                  (523,022
                  )
                  
                  (421,603
                  )Recoveries
                      on loans previously charged off
                  
                  
                  343,815
                  
                  
                  19,641
                  
                  
                  21,176Allowances
                      acquired in acquisition
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,488,623Balance
                      at end of year
                  
                  $
                  6,144,119
                  
                  $
                  5,763,923
                  
                  $
                  5,102,304
 
 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 outstanding loans and commitments, all of which were
            made under
            normal credit terms and did not involve more than normal risk of collection.
            The
            aggregate amounts of these loans were $8,077,988 and $6,142,874 at December
            31,
            2007 and 2006, respectively. During the year ended December 31, 2007,
            new loans
            of $8,647,678 were made and payments totaled $6,336,287. During the year
            ended
            December 31, 2006, new loans of $1,994,343 were made and payments totaled
            $7,637,382.
 
 The
            Bank
            held no loans for sale at December 31, 2007 and 2006.
 
 54
  **Note
            5 - Premises and Equipment**
 
 Premises
            and equipment at December 31 are summarized as follows:
 
 **2007**
                  
                  **2006**Land
                  
                  $
                  5,371,888
                  
                  $
                  4,716,895Buildings
                  
                  
                  13,437,635
                  
                  
                  13,709,581Leasehold
                      Improvements
                  
                  
                  268,728
                  
                  
                  268,728Land
                      Improvements
                  
                  
                  286,424
                  
                  
                  292,518Furniture
                      and equipment
                  
                  
                  4,620,676
                  
                  
                  4,505,787Premises
                      and equipment
                  
                  
                  23,985,351
                  
                  
                  23,493,509Less:
                      accumulated depreciation
                  
                  
                  6,020,441
                  
                  
                  5,206,542Premises
                      and equipment, net
                  
                  $
                  17,964,910
                  
                  $
                  18,286,967
 
 **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, 2007, and December 31, 2006. The bank-owned life insurance
            policies
            are recorded in other assets at their cash surrender values of $16,099,371
            and
            $15,526,615 at December 31, 2007 and 2006, respectively.
 
 **Note
            7 - Intangible Assets**
 
 Amortized
            intangible assets at December 31, 2007 and 2006 are summarized as
            follows:
 
 **2007**
                  
                  **2006**Core
                      deposit intangible
                  
                  $
                  4,767,000
                  
                  $
                  4,767,000Less:
                      Accumulated amortization
                  
                  
                  3,371,001
                  
                  
                  2,742,001Core
                      deposit intangible, net
                  
                  $
                  1,395,999
                  
                  $
                  2,024,999
 
 Amortization
            expense for all intangible assets subject to amortization was $629,000
            during
            the year ended December 31, 2007, $734,000 during the year ended December
            31,
            2006, and $408,907 during the year ended December 31, 2005. Estimated
            amortization expense for the next five succeeding years ending December
            31 are
            as follows:
 2008
                    
                    $
                    512,0002009
                    
                    $
                    314,0002010
                    
                    $
                    244,0002011
                    
                    $
                    176,0002012
                    
                    $
                    111,000
 The
            balance of goodwill was $29,641,234 at December 31, 2007 and December
            31, 2006.
            This resulted in total intangible assets of $31,037,233 at December 31,
            2007,
            and $31,666,233 at December 31, 2006.
 
 55
 
 **Note
            8 - Deposits**
 
 Deposit
            balances and interest expense and average rates paid for the years ended
            December 31, 2007, December 31, 2006, and December 31, 2005 are summarized
            as
            follows:
 
 **December
                      31, 2007**
                  
                  **December
                      31, 2006****Actual**
                    **Balance**
                  
                  **Interest**
                    **Expense**
                  
                  **Average**
                    **Rate**
                  
                  **Actual**
                    **Balance**
                  
                  **Interest**
                    **Expense**
                  
                  **Average**
                    **Rate**Noninterest-bearing
                  
                  $
                  43,571,218
                  
                  $
                  -
                  
                  
                  -
                  
                  $
                  37,762,084
                  
                  $
                  -
                  
                  
                  -Interest-bearing
                      checking
                  
                  
                  58,409,636
                  
                  
                  917,033
                  
                  
                  1.74%
                  
                  
                  52,778,385
                  
                  
                  662,072
                  
                  
                  1.29%Money
                      market deposit
                  
                  
                  129,687,365
                  
                  
                  4,908,496
                  
                  
                  3.89
                  
                  
                  117,632,286
                  
                  
                  4,186,931
                  
                  
                  3.82Savings
                  
                  
                  12,037,608
                  
                  
                  82,351
                  
                  
                  0.58
                  
                  
                  16,026,580
                  
                  
                  149,807
                  
                  
                  0.77Certificates
                      of deposit
                  
                  
                  347,058,995
                  
                  
                  16,407,088
                  
                  
                  4.79
                  
                  
                  338,602,436
                  
                  
                  13,104,204
                  
                  
                  4.09Total
                      deposits
                  
                  $
                  590,764,822
                  
                  $
                  22,314,968
                  
                  
                  3.88%
                  
                  $
                  562,801,771
                  
                  $
                  18,103,014
                  
                  
                  3.37%
  **December
                      31, 2005****Actual**
                    **Balance**
                  
                  **Interest**
                    **Expense**
                  
                  **Average**
                    **Rate**Noninterest-bearing
                  
                  $
                  35,225,404
                  
                  $
                  -
                  
                  
                  -Interest-bearing
                      checking
                  
                  
                  50,262,906
                  
                  
                  210,499
                  
                  
                  0.57
                  %Money
                      market deposit
                  
                  
                  104,420,774
                  
                  
                  1,791,093
                  
                  
                  2.29Savings
                  
                  
                  23,654,258
                  
                  
                  158,721
                  
                  
                  0.61Certificates
                      of deposit
                  
                  
                  303,980,459
                  
                  
                  6,816,566
                  
                  
                  2.95Total
                      deposits
                  
                  $
                  517,543,801
                  
                  $
                  8,976,879
                  
                  
                  2.41
                  %
 
 Contractual
            maturities of certificates of deposit as of December 31, 2007 and 2006,
            are as
            follows:
 
 **2007**
                  
                  **2006**Under
                      1 year
                  
                  $
                  319,912,823
                  
                  $
                  298,589,7311
                      to 2 years
                  
                  
                  18,074,932
                  
                  
                  20,364,9632
                      to 3 years
                  
                  
                  8,050,396
                  
                  
                  12,458,8203
                      to 4 years
                  
                  
                  317,539
                  
                  
                  6,709,8834
                      years or greater
                  
                  
                  703,305
                  
                  
                  479,039Total
                  
                  $
                  347,058,995
                  
                  $
                  338,602,436
 
 Certificates
            of deposit in excess of $100,000 totaled $132,186,117 and $123,835,024
            at
            December 31, 2007 and 2006, respectively, and may not be fully insured
            by the
            FDIC. Interest paid on deposits and other borrowings was $25,924,506
            for the
            year ended December 31, 2007, $21,277,860, for the year ended December
            31, 2006,
            and $10,576,971 for the year ended December 31, 2005.
 
 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 $3,426,486 and $4,636,009
            at
            December 31, 2007 and 2006, respectively.
 
 56
  The
            deposits of the Bank are insured by the Deposit Insurance Fund (DIF),
            which is
            administered by the FDIC. The Bank’s annual DIF premium rates were $0.054,
            $0.014, and $0.014 per $100 of deposits for the years ended December
            31, 2007,
            December 31, 2006 and December 31, 2005, respectively.
 
 **Note
            9 - Borrowed Money**
 
 As
            of
            December 31, 2007, the Company had $64.5 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 $194 million. The unused portion of the line of credit
            available
            to the Company at December 31, 2007, was approximately $130 million.
            These
            advances had interest rates ranging from 1.24% to 6.25% at December 31,
            2007,
            and December 31, 2006. In addition, the Company had a mark-to-market
            adjustment
            on advances acquired in the Trinity acquisition which had a debit balance
            of
            $35,000 at December 31, 2007, which is considered to be due in less than
            one
            year. 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 $37.0 million
            at
            December 31, 2007, and $12.0 million at December 31, 2006.
 
 The
            Company also had $6.0 million in repurchase agreements (“repos”) from JP Morgan
            Chase Bank, NA (“JP Morgan”) at December 31, 2007. 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. One repo, which totaled $3.0 million with a fixed
            interest
            rate of 3.66%, had a two-year one-time call option with a ten-year maturity
            date. After the two-year period, the repo may be called by JP Morgan,
            or it may
            remain outstanding for the remaining eight-year period at the original
            interest
            rate of 3.66%. The remaining repo had a balance of $3.0 million and a
            fixed rate
            of 4.48% for five years.
 
 Maturities
            of borrowed money at December 31 are as follows:
 
 **2007**
                  
                  **2006**Borrowed
                      money due:Less
                      than 1 year
                  
                  $
                  17,965,000
                  
                  $
                  17,985,0001
                      to 2 years
                  
                  
                  8,000,000
                  
                  
                  13,000,0002
                      to 3 years
                  
                  
                  8,000,000
                  
                  
                  3,000,0003
                      to 4 years
                  
                  
                  1,500,000
                  
                  
                  8,000,0004
                      to 5 years
                  
                  
                  25,000,000
                  
                  
                  1,500,0005
                      to 10 years
                  
                  
                  8,000,000
                  
                  
                  18,000,000After
                      10 years
                  
                  
                  2,000,000
                  
                  
                  2,000,000Total
                      borrowed money
                  
                  $
                  70,465,000
                  
                  $
                  63,485,000
  57
  **Note
            10 - Subordinated Debt**
 
 In
            order
            to provide financing for the cash portion of the Trinity acquisition,
            on October
            28, 2005, the Company completed a private placement of an aggregate amount
            of
            $15,000,000 in trust preferred securities, liquidation amount $1,000
            per
            security (the "Preferred Securities"), through a newly formed Delaware
            statutory
            trust subsidiary, CSBC Statutory Trust I (the "Trust").
  In
            connection with the issuance of the Preferred Securities, on October
            28, 2005,
            the Company entered into an Indenture (the "Indenture") by and between
            the
            Company and Wilmington Trust Company, as trustee, and an Amended and
            Restated
            Declaration of Trust (the "Trust Agreement") among the Company, as Sponsor,
            Wilmington Trust Company, as Delaware and Institutional Trustee, and
            the
            administrative trustees of the Trust.
  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.
  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.
 
 58
 
 **Note
            11 - Income Taxes**
 
 The
            provision for income taxes for the years ended December 31 st are
            summarized below:
 
 **2007**
                  
                  **2006**
                  
                  **2005**Currently
                      payable:Federal
                  
                  $
                  2,008,139
                  
                  $
                  2,594,290
                  
                  $
                  864,250State
                  
                  
                  414,758
                  
                  
                  431,185
                  
                  
                  234,350Total
                      current
                  
                  
                  2,422,897
                  
                  
                  3,025,475
                  
                  
                  1,098,600
 
 
 Deferred:Federal
                  
                  
                  (350,237
                  )
                  
                  (347,236
                  )
                  
                  257,008State
                  
                  
                  (125,390
                  )
                  
                  (61,119
                  )
                  
                  (32,796
                  )Total
                      deferred
                  
                  
                  (475,628
                  )
                  
                  (408,355
                  )
                  
                  224,212Total
                      income taxes
                  
                  $
                  1,947,269
                  
                  $
                  2,617,120
                  
                  $
                  1,322,812
 
 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 st :
 
 **2007**
                  
                  **2006**
                  
                  **2005**Federal
                      income taxes at statutory rate
                  
                  $
                  2,588,073
                  
                  $
                  2,744,479
                  
                  $
                  1,562,477Effect
                      of federal tax exempt interest
                  
                  
                  (389,183
                  )
                  
                  (151,624
                  )
                  
                  (135,946
                  )State
                      income taxes, net of federal benefit
                  
                  
                  190,983
                  
                  
                  244,244
                  
                  
                  133,026Increase
                      in cash value of life insurance
                  
                  
                  (314,794
                  )
                  
                  (237,603
                  )
                  
                  (202,601
                  )Other
                  
                  
                  (127,810
                  )
                  
                  17,624
                  
                  
                  (34,144
                  )$
                  1,947,269
                  
                  $
                  2,617,120
                  
                  $
                  1,322,812Effective
                      tax rate
                  
                  
                  25.6%
                  
                  
                  32.4%
                  
                  
                  28.8%
 
 Income
            taxes paid for the years ended December 31, 2007, 2006, and 2005 were
            $3,003,664, $3,142,078, and $2,773,660, respectively.
 
 59
 
 The
            tax
            effects of temporary differences that give rise to significant portions
            of
            deferred tax assets and liabilities at December 31 are as follows:
 
 **2007**
                  
                  **2006**Deferred
                      tax assetsDeferred
                      compensation
                  
                  $
                  990,616
                  
                  $
                  871,763Unrealized
                      loss on securities available for sale
                  
                  
                  215,485
                  
                  
                  640,326Allowance
                      for loan losses
                  
                  
                  2,342,897
                  
                  
                  2,211,211Capital
                      loss carryforward
                  
                  
                  282,052
                  
                  
                  338,196Other
                  
                  
                  167,339
                  
                  
                  110,810Gross
                      deferred tax assets
                  
                  
                  3,998,390
                  
                  
                  4,172,326Deferred
                      tax liabilitiesExcess
                      carrying value of assets acquired forfinancial
                      reporting purposes over tax basis
                  
                  
                  1,028,041
                  
                  
                  1,307,587Deferred
                      loan fees
                  
                  
                  194,606
                  
                  
                  144,095Other
                  
                  
                  102,615
                  
                  
                  98,283Gross
                      deferred tax liabilities
                  
                  
                  1,325,261
                  
                  
                  1,549,965Net
                      deferred tax asset
                  
                  $
                  2,673,128
                  
                  $
                  2,622,361
  The
            Company has adopted the provisions of Financial Accounting Standards
            Board
            ("FASB") 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 federal and state income tax returns are subject to examination
            for the years 2004, 2005 and 2006.
  The
            Company, in accordance with SFAS No. 109, did not record a deferred tax
            liability of approximately $3.1 million as of December 31, 2007, related
            to the
            cumulative special bad debt deduction for savings and loan associations
            recognized for income tax reporting prior to September 30, 1988, Citizen
            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.
 
 **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.
 
 60
 
 Commitments
            to extend credit that include both fixed and variable rates as of December
            31
            are as follows:
 
 **2007**
                  
                  **2006**Residential
                      mortgage loan commitments
                  
                  $
                  7,160,455
                  
                  $
                  6,193,000Non-residential
                      mortgage loan commitments
                  
                  
                  20,987,431
                  
                  
                  34,842,430Commercial
                      loan commitments
                  
                  
                  6,559,700
                  
                  
                  1,535,000Consumer
                      loan commitments
                  
                  
                  6,840,137
                  
                  
                  3,857,000Unused
                      lines of credit:Commercial
                  
                  
                  38,120,483
                  
                  
                  43,424,493Consumer
                  
                  
                  71,831,349
                  
                  
                  61,912,898
 
 The
            Company also had various leases in place to provide office space for
            two
            full-service offices and three loan production offices. The amount paid
            for this
            leased office space totaled $370,410 for the year ended December 31,
            2007,
            $337,897 for the year ended December 31, 2006, and $122,876 for the year
            ended
            December 31, 2005. Projected lease payments over the next five years
            are
            expected to be $440,000 for 2008, $420,000 for 2009, $250,000 for 2010,
            $186,000
            for 2011, and $186,000 for 2012.
 
 **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.
 
 61
 
 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, 2007,
            the
            Bank’s tangible capital and core capital were $65,276,000, or 8.74% of tangible
            assets, and total capital was $71,420,000, or 11.21% 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
                      Provisions****Amount**
                  
                  **Ratio**
                  
                  **Amount**
                  
                  **Ratio**
                  
                  **Amount**
                  
                  **Ratio**(Dollars
                      in Thousands)
                  
                  (Dollars
                      in Thousands)
                  
                  (Dollars
                      in Thousands)**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
                  %
 
 **As
                      of December 31, 2006:**Total
                      Risk-Based Capital(to
                      Risk-Weighted Assets)
                  
                  $
                  70,440
                  
                  
                  11.81
                  %
                  $
                  47,733
                  
                  
                  8.00
                  %
                  $
                  59,666
                  
                  
                  10.00
                  %Tier
                      1 Capital(to
                      Risk-Weighted Assets)
                  
                  
                  64,676
                  
                  
                  10.81
                  %
                  
                  23,866
                  
                  
                  4.00
                  %
                  
                  35,799
                  
                  
                  6.00
                  %Tier
                      1 Capital(to
                      Adjusted Total Assets)
                  
                  
                  64,676
                  
                  
                  9.11
                  %
                  
                  28,384
                  
                  
                  4.00
                  %
                  
                  35,481
                  
                  
                  5.00
                  %Tangible
                      Capital(to
                      Adjusted Total Assets)
                  
                  
                  64,676
                  
                  
                  9.11
                  %
                  
                  10,644
                  
                  
                  1.50
                  %
                  
                  21,288
                  
                  
                  3.00
                  %
 
 On
            May
            23, 2002, the 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, 2007 and
            2006.
 
 62
 
 **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. The plan also provides
            for
            discretionary employer contributions. During 2007, 2006 and 2005, no
            discretionary employer contributions were made to the 401(k) plan. Total
            expense
            relating to this plan was $171,926 for the year ended December 31, 2007,
            $165,524 for the year ended December 31, 2006, and $131,023 for the year
            ended
            December 31, 2005.
 
 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 $463,860 for the year ended December 31, 2007,
            $423,290
            for the year ended December 31, 2006, and $374,505 for the year ended
            December
            31, 2005.
 
 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 2007, 19,456 shares vested and no
            shares were
            forfeited. In addition, 10,000 shares were granted during 2007 with 5-year
            cliff
            vesting. At December 31, 2007, 5,038 restricted shares remained unissued
            and
            available for grants under the 2003 RRP. Total expense for the 2003 RRP
            amounted
            to $302,144 in 2007, $279,816 in 2006 and $279,816 in 2005.
 
 1999
            Stock Option Plan **-** On
            April
            12, 1999, the Company’s shareholders 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 2007, there were there were no options granted, 14,985
            shares
            were exercised, and no shares were forfeited under the 1999 Stock Option
            Plan.
            All of the 14,985 shares exercised were exercised for cash. At December
            31,
            2007, 1,612 options remained unissued and available for grants under
            the 1999
            Stock Option Plan.
 
 63
  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 2007, there were 8,000 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 1,000 options were forfeited.
            At December
            31, 2007, 9,475 options remained unissued and available for grants under
            the
            2003 Stock Option Plan.
 
 The
            following is a summary of stock option activity and related information
            for the
            years ended December 31, 2007, 2006 and 2005.
  **2007**
                  
                  **2006**
                  
                  **2005****Weighted
                      Avg.**
                  
                  
                  
                  **Weighted
                      Avg.**
                  
                  
                  
                  **Weighted
                      Avg.****Options**
                  
                  **Exercise
                      Price**
                  
                  **Options**
                  
                  **Exercise
                      Price**
                  
                  **Options**
                  
                  **Exercise
                      Price**Outstanding-Beginning
                      of period
                  
                  
                  740,871
                  
                  $
                  12.95
                  
                  
                  772,680
                  
                  $
                  12.22
                  
                  
                  793,151
                  
                  $
                  12.58Granted
                  
                  
                  8,000
                  
                  
                  12.47
                  
                  
                  5,894
                  
                  
                  12.70
                  
                  
                  19,000
                  
                  
                  12.96Exercised
                  
                  
                  (14,985
                  )
                  
                  5.61
                  
                  
                  (26,203
                  )
                  
                  5.61
                  
                  
                  (24,471
                  )
                  
                  5.75Forfeited
                  
                  
                  (1,000
                  )
                  
                  12.72
                  
                  
                  (11,500
                  )
                  
                  14.68
                  
                  
                  (15,000
                  )
                  
                  15.04Outstanding-end
                      ofperiod
                  
                  
                  732,886
                  
                  $
                  13.09
                  
                  
                  740,871
                  
                  $
                  12.95
                  
                  
                  772,680
                  
                  $
                  12.22Exercisable-end
                      ofperiod
                  
                  
                  709,586
                  
                  $
                  13.11
                  
                  
                  718,971
                  
                  $
                  12.96
                  
                  
                  747,680
                  
                  $
                  12.20Weighted
                      average fairvalue
                      of optionsgrantedduring
                      the period
                  
                  
                  
                  
                  $
                  4.27
                  
                  
                  
                  
                  $
                  4.35
                  
                  
                  
                  
                  $
                  4.60
 
 Exercise
            prices for options outstanding as of December 31, 2007 and 2006, ranged
            from
            $5.14 to $15.06. The weighted average remaining contractual life of those
            options was approximately four years at December 31, 2007, and five years
            at
            December 31, 2006.
 
 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
            $563,559 with an interest rate of 7.25% and $676,271 with an interest
            rate of
            8.25% at December 31, 2007 and 2006, 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 $631,188 with an interest rate of
            7.25% and
            $701,320 with an interest rate of 8.25% at December 31, 2007 and 2006,
            respectively. Unallocated shares, totaling 152,600 shares at December
            31, 2007,
            are excluded for the calculation of earnings per share.
 
 64
  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, 2007, 272,265 shares have been allocated
            to
            participants and 152,600 shares remain unallocated. The fair value of
            the
            unallocated shares was $1.5 million at December 31, 2007. 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 $204,442, $215,287, and $209,419 as compensation expense
            in
            the years ended December 31, 2007, December 31, 2006, and December 31,
            2005,
            respectively.
 
 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.
 
 The
            carrying amount of repurchase agreements approximates fair value due
            to the
            short-term nature of the agreements.
 
 Fair
            value for the advances from the Federal Home Loan Bank is based on discounted
            cash flows using current interest rates.
 
 At
            December 31, 2007 and 2006, 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, 2007 and 2006, the carrying amounts and fair values of these
            off-balance sheet financial instruments were immaterial.
 
 65
 
 The
            Company has used management’s best estimates of fair values of financial
            instruments based on the above assumptions. This presentation does not
            include
            certain financial instruments, nonfinancial instruments or certain intangible
            assets such as customer relationships, deposit base intangibles, or goodwill.
            Accordingly, the aggregate fair value amounts presented do not represent
            the
            underlying value of the Company. The estimated fair values **** of
            financial instruments as of December 31 were as follows:
 
 **2007**
                  
                  **2006****Carrying
                      Amount**
                  
                  **Estimated
                      Fair Value**
                  
                  **Carrying
                      Amount**
                  
                  **Estimated
                      Fair Value****Financial
                      assets:**Cash
                      and due from banks
                  
                  $
                  14,285,431
                  
                  $
                  14,285,431
                  
                  $
                  17,581,168
                  
                  $
                  17,581,168Interest-earning
                      bank balances
                  
                  
                  15,454,043
                  
                  
                  15,454,043
                  
                  
                  8,639,809
                  
                  
                  8,639,809Investments
                      and mortgage-backed securities
                  
                  
                  116,411,482
                  
                  
                  113,367,543
                  
                  
                  126,017,396
                  
                  
                  122,247,335Loans
                  
                  
                  559,955,975
                  
                  
                  557,407,196
                  
                  
                  515,401,738
                  
                  
                  506,460,790**Financial
                      liabilities:**Deposits
                  
                  
                  590,764,822
                  
                  
                  580,344,322
                  
                  
                  562,801,771
                  
                  
                  549,117,428Repurchase
                      agreements
                  
                  
                  10,355,320
                  
                  
                  10,355,320
                  
                  
                  7,015,488
                  
                  
                  7,015,488Borrowed
                      money
                  
                  
                  85,929,000
                  
                  
                  87,379,471
                  
                  
                  78,949,000
                  
                  
                  78,660,166
 
 **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, 2007, the Company excluded 586,145 of the 732,886 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,
            2007. The following is a summary of the computation of basic and diluted
            earnings per share for the years ended December 31st:
 
 66
  **2007**
                  
                  **2006**
                  
                  **2005**Net
                      income
                  
                  $
                  5,664,740
                  
                  $
                  5,454,877
                  
                  $
                  3,272,709Weighted
                      average outstanding shares
                  
                  
                  7,688,022
                  
                  
                  8,017,956
                  
                  
                  7,207,368Basic
                      earnings per share
                  
                  $
                  0.74
                  
                  $
                  0.68
                  
                  $
                  0.45Weighted
                      average outstanding shares
                  
                  
                  7,688,022
                  
                  
                  8,017,956
                  
                  
                  7,207,368Dilutive
                      effect of stock options
                  
                  
                  65,917
                  
                  
                  77,320
                  
                  
                  90,851Weighted
                      average diluted shares
                  
                  
                  7,753,940
                  
                  
                  8,095,276
                  
                  
                  7,298,219Diluted
                      earnings per share
                  
                  $
                  0.73
                  
                  $
                  0.67
                  
                  $
                  0.45
 
 The
            Company had 9,062,727 shares of common stock issued and outstanding as
            of
            September 30, 2002. In March
            2003, the Company’s Board of Directors announced the authorization to repurchase
            of up to 343,027 shares of outstanding common stock. The Company repurchased
            342,200 shares of stock at an average price of $13.66 under this authority
            in
            October 2003. During October 2003 the Company’s Board of Directors announced the
            authorization to repurchase up to 879,900 shares, or 10% of the outstanding
            common stock. The Company repurchased 877,235 shares of stock at an average
            price of $13.80 under this authority by May 2004. During May 2004, the
            Company’s
            Board of Directors authorized the repurchase of up to 815,000 shares,
            or 10% of
            the outstanding common stock. The Company repurchased 815,000 shares
            of stock at
            an average price of $13.09 under this authority in February 2005. During
            February 2005, the Board of Directors authorized the repurchase of 370,000
            shares, or 5% of the outstanding common stock. The Company repurchased
            370,000
            of stock at an average price of $12.49 under this authority in January
            2006.
            During January 2006, the Board of Directors authorized the repurchase
            of 200,000
            shares, or 2.5% of the outstanding stock. The Company repurchased 200,000
            shares
            of stock at an average price of $12.78 under this authority in January
            2007.
            During January 2007, the Company’s Board of Directors authorized the repurchase
            of up to 400,000 shares, or 5% of the outstanding common stock. The Company
            repurchased 400,000 shares of stock at an average price of $12.77 under
            this
            authority in November 2007. During November 2007, the Company’s Board of
            Directors authorized the repurchase of up to 200,000 shares, or 2.5%
            of the
            outstanding common stock. As of December 31, 2007, the Company had repurchased
            106,648 shares of stock at an average price of $11.63 under this authorization
            and had 93,352 shares remaining.
 
 As
            of
            December 31, 2007, a total of 3,111,083 shares, or 34.3% of the outstanding
            shares of common stock, have been repurchased under these plans at an
            average
            price of $13.17 per share.
 
 67
 
 **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, 2007
            and 2006, and for the years ended December 31, 2007, 2006 and 2005.
 
 **Condensed
            Statements of Financial Condition**
  **2007**
                  
                  **2006**AssetsCash
                      and cash equivalents
                  
                  $
                  995,258
                  
                  $
                  2,204,208Investment
                      in securities available-for-sale
                  
                  
                  1,978,950
                  
                  
                  2,198,120Investment
                      in subsidiary
                  
                  
                  96,412,730
                  
                  
                  96,548,690Other
                      assets
                  
                  
                  166,066
                  
                  
                  649,650Total
                      assets
                  
                  $
                  99,553,004
                  
                  $
                  101,600,668Liabilities
                      and Stockholders' EquityLiabilities
                  
                  $
                  15,519,783
                  
                  $
                  15,639,433Stockholders'
                      equity
                  
                  
                  84,033,221
                  
                  
                  85,961,235Total
                      liabilities and stockholders' equity
                  
                  $
                  99,553,004
                  
                  $
                  101,600,668
 68
  **Condensed
            Statements of Operations**
 
 **2007**
                  
                  **2006**
                  
                  **2005**Interest
                      income
                  
                  $
                  170,784
                  
                  $
                  151,708
                  
                  $
                  124,703Interest
                      expense
                  
                  
                  (942,530
                  )
                  
                  (942,530
                  )
                  
                  (164,943
                  )Other
                      noninterest income
                  
                  
                  2,273
                  
                  
                  92,964
                  
                  
                  7,567Other
                      noninterest expenses
                  
                  
                  (1,058,972
                  )
                  
                  (755,776
                  )
                  
                  (725,991
                  )Loss
                      before income taxes and undistributedearnings
                      from subsidiaries
                  
                  
                  (1,828,445
                  )
                  
                  (1,453,634
                  )
                  
                  (758,664
                  )Income
                      taxes
                  
                  
                  703,000
                  
                  
                  563,000
                  
                  
                  295,218Loss
                      before undistributed earnings fromsubsidiaries
                  
                  
                  (1,125,445
                  )
                  
                  (890,634
                  )
                  
                  (463,446
                  )Equity
                      in undistributed earnings of subsidiaries
                  
                  
                  6,790,155
                  
                  
                  6,345,511
                  
                  
                  3,736,155Net
                      income
                  
                  $
                  5,664,710
                  
                  $
                  5,454,877
                  
                  $
                  3,272,709
  69
 
 Condensed
            Statements of Cash Flows
 
 **2007**
                  
                  **2006**
                  
                  **2005****Operating
                      activities**Net
                      income
                  
                  $
                  5,664,710
                  
                  $
                  5,454,877
                  
                  $
                  3,272,709Adjustments
                      to reconcile net income to netCash
                      provided by operating activities:Gain
                      on sale of investments
                  
                  
                  -
                  
                  
                  (92,964
                  )
                  
                  (7,500
                  )Impairment
                      of investment securities
                  
                  
                  161,910
                  
                  
                  -
                  
                  
                  -Equity
                      in undistributed (earnings) ofsubsidiaries
                  
                  
                  (6,790,155
                  )
                  
                  (6,345,511
                  )
                  
                  (3,736,155
                  )Allocation
                      of shares to ESOP
                  
                  
                  260,688
                  
                  
                  267,736
                  
                  
                  269,864Stock
                      option expense
                  
                  
                  27,967
                  
                  
                  25,194
                  
                  
                  -Vesting
                      of shares issued for the RRP
                  
                  
                  302,144
                  
                  
                  279,816
                  
                  
                  279,816Increase
                      in other operating subsidiaries
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (623,845
                  )(Decrease)
                      increase in other operatingliabilities
                  
                  
                  494,902
                  
                  
                  (7,234
                  )
                  
                  -Net
                      cash provided by (used in) operating activities
                  
                  
                  122,166
                  
                  
                  (418,086
                  )
                  
                  (545,111
                  )**Investing
                      activities**Proceeds
                      from the sale of investments
                  
                  
                  -
                  
                  
                  191,014
                  
                  
                  507,500Purchase
                      of investments available-for-sale
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (200,000
                  )Net
                      cash used in investing activities
                  
                  
                  -
                  
                  
                  191,014
                  
                  
                  307,500**Financing
                      activities**Repurchase
                      of common stock
                  
                  
                  (6,446,335
                  )
                  
                  (2,624,719
                  )
                  
                  (5,654,999
                  )Contributed
                      capital to bank subsidiary
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (15,000,000
                  )Dividends
                      received from bank subsidiary
                  
                  
                  7,500,000
                  
                  
                  6,000,000
                  
                  
                  6,000,000Increase
                      in borrowed money
                  
                  
                  -
                  
                  
                  -
                  
                  
                  15,464,000Exercise
                      of options
                  
                  
                  83,991
                  
                  
                  135,793
                  
                  
                  140,670Dividends
                      to stockholders
                  
                  
                  (2,468,772
                  )
                  
                  (2,411,060
                  )
                  
                  (2,067,808
                  )Net
                      cash provided by (used in) financingactivities
                  
                  
                  (1,331,116
                  )
                  
                  1,100,014
                  
                  
                  (1,118,137
                  )Net
                      increase (decrease) in cash and cash equivalents
                  
                  
                  (1,208,950
                  )
                  
                  872,942
                  
                  
                  (1,355,748
                  )Cash
                      and cash equivalents, beginning of year
                  
                  
                  2,204,208
                  
                  
                  1,331,266
                  
                  
                  2,687,014Cash
                      and cash equivalents, end of year
                  
                  $
                  995,258
                  
                  $
                  2,204,208
                  
                  $
                  1,331,266
  70
  **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, 2007. 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, 2007. The Company’s independent registered public accounting firm has issued
            an attestation report on management’s assessment of the Company’s internal
            control over financial reporting. That report is presented on the following
            page
            of this report.
 
 71
  
  **REPORT
            OF INDEPENDENT REGISTERD PUBLIC ACCOUNTING FIRM**
 
 
 The
            Board
            of Directors
 Citizens
            South Banking Corporation
 Gastonia,
            North Carolina
 
 We
            have
            audited management’s assessment, included in the accompanying Management’s
            Annual Report on Internal Control Over Financial Reporting, that Citizens
            South
            Banking Corporation and subsidiaries (the “Company”) maintained effective
            internal control over financial reporting as of December 31, 2007, based
            on
            criteria established in *Internal
            Control-Integrated Framework* issued
            by the Committee of Sponsoring Organizations of the Treadway Commission
            (COSO).
            The Company’s management is responsible for maintaining effective internal
            control over financial reporting and for its assessment of the effectiveness
            of
            internal control over financial reporting. Our responsibility is to express
            an
            opinion on management’s assessment and an opinion on the effectiveness of the
            company’s internal control over financial reporting based on our audit.
 
 We
            conducted our audit 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 effective
            internal control over financial reporting was maintained in all material
            aspects. Our audit included obtaining an understanding of internal control
            over
            financial reporting, evaluating management’s assessment, testing and evaluating
            the design and operating effectiveness of internal control, and performing
            such
            other procedures as we considered necessary in the circumstances. We
            believe
            that our audit provides a reasonable basis for our opinion.
 
 A
            company’s internal control over financial reporting is a process designed to
            provide reasonable assurance regarding the reliability of financial reporting
            and the preparation of financial statements for external purposes in
            accordance
            with accounting principles generally accepted in the United States of
            America. A
            company’s internal control over financial reporting includes those policies and
            procedures that (1) pertain to the maintenance of records that, in reasonable
            detail, accurately and fairly reflect the transactions and dispositions
            of the
            assets of the company; (2) provide reasonable assurance that transactions
            are
            recorded as necessary to permit preparation of financial statements in
            accordance with accounting principles generally accepted in the United
            States of
            America, and that receipts and expenditures of the company are being
            made only
            in accordance with authorizations of management and directors of the
            company;
            and (3) 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.
 
 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.
 
 In
            our
            opinion, management’s assessment that the Company maintained effective internal
            control over financial reporting as of December 31, 2007, is fairly stated,
            in
            all material respects, based on criteria established in *Internal
            Control-Integrated Framework* issued
            by COSO. Also in our opinion, the Company maintained, in all material
            aspects,
            effective internal control over financial reporting as of December 31,
            2007,
            based on criteria established in *Internal
            Control-Integrated Framework* issued
            by COSO.
  72
  We
            have
            also audited, in accordance with the standards of the Public Company
            Accounting
            Oversight Board (United States), the consolidated statements of condition
            of the
            Company as of December 31, 2007 and 2006, 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,
            2007, and our report dated March 14, 2008, expressed an unqualified opinion
            on
            these consolidated financial statements.
 
 /s/
            Cherry, Bekaert & Holland, L.L.P.
 
 Gastonia,
            North Carolina
 March
            14,
            2008
 
 73
 
 **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.
 
 74
 
 **PART
            IV**
 
 **ITEM
                    15.**
                  **Exhibits
                      and Financial Statement
                      Schedules**
 
 **A.**
                  **Index
                      of 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
                  Bylaws
                      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
 
 4.1
                  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)
 
 10.1
                  Employment
                      Agreement with Kim S. Price dated May 17,
                      2004
 
 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), originally filed
                      with the
                      Commission on December 22, 1997
 
 10.5
                  Severance
                      Agreement with Gary F. Hoskins dated May 17, 2004. (Incorporated
                      by
                      reference to the Annual Report on Form 10-K (File No. 0-23971),
                      filed with
                      the Commission on March 16, 2005)
 
 10.6
                  Severance
                      Agreement with Paul L. Teem, Jr. dated May 17, 2004. (Incorporated
                      by
                      reference to the Annual Report on Form 10-K (File No. 0-23971),
                      filed with
                      the Commission on March 16, 2005)
 
 10.7
                  Severance
                      Agreement with Michael R. Maguire dated May 17, 2004. (Incorporated
                      by
                      reference to the Annual Report on Form 10-K (File No. 0-23971),
                      filed with
                      the Commission on March 16, 2005)
 
 10.8
                  Severance
                      Agreement with Daniel M. Boyd, IV dated May 17, 2004. (Incorporated
                      by
                      reference to the Annual Report on Form 10-K (File No. 0-23971),
                      filed with
                      the Commission on March 16, 2005)
 
 10.9
                  Severance
                      Agreement with V. Burton Brinson, Jr. dated May 17, 2004. (Incorporated
                      by
                      reference to the Annual Report on Form 10-K (File No. 0-23971),
                      filed with
                      the Commission on March 16, 2005)
 
 10.10
                  Salary
                      Continuation 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)
 
 10.11
                  Salary
                      Continuation 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)
 
 75
 
 10.12
                  Salary
                      Continuation 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)
 
 10.13
                  Salary
                      Continuation 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)
 
 10.14
                  Salary
                      Continuation 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)
 
 10.15
                  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)
 
 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)
 
 10.23
                  Amended
                      Deferred Compensation and Income Continuation 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)
 
 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)
 
 76
  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)
 
 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)
 
 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)
 
 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)
 
 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)
 
 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)
 
 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)
 
 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, 2006
 
 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
                      2002
 
 32
                  Statement
                      of Chief Executive Officer and Chief Financial Officer furnished
                      pursuant
                      to Section 906 of the Sarbanes-Oxley Act of
                      2002
 
 77
  **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 Corporation**Date:
                  March
                      14, 2008
                  
                  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 OfficerDate:
                  March
                      14, 2008
                  
                  Date:
                  March
                      14, 2008
  By:
                  /s/
                      David W. Hoyle
                  
                  By:
                  /s/
                      Ben R. Rudisill, IIDavid
                      W. Hoyle
                  
                  
                  Ben
                      R. Rudisill, IIChairman
                  
                  
                  Vice
                      ChairmanDate:
                  March
                      14, 2008
                  
                  Date:
                  March
                      14, 2008
  By:
                  /s/
                      Eugene R. Matthews, II
                  
                  By:
                  /s/
                      Charles D. MasseyEugene
                      R. Matthews, II
                  
                  
                  Charles
                      D. MasseyDirector
                  
                  
                  DirectorDate:
                  March
                      14, 2008
                  
                  Date:
                  March
                      14, 2008
  By:
                  /s/
                      James J. Fuller
                  
                  By:
                  /s/
                      David McGuirtJames
                      J. Fuller
                  
                  
                  David
                      McGuirtDirector
                  
                  
                  DirectorDate:
                  March
                      14, 2008
                  
                  Date:
                  March
                      14, 2008
 
 78