<PAGE>
 
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington  D.C. 20549

                                   FORM 10-Q

 [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934

     For the quarterly period ended  December 31, 1998
                       
                                       OR
 [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES 
EXCHANGE ACT OF 1934

     For the transition period from __________________ to ____________________


                        Commission File Number: 0-21083


                         SOUTH STREET FINANCIAL CORP.
                         ----------------------------
            (Exact name of registrant as specified in its charter)

            North Carolina                               56-1973261
            --------------                               ----------
       (State or other jurisdiction of               (I.R.S. Employer
        incorporation or organization)                Identification No.)


                             155 West South Street
                        Albemarle, North Carolina 28001
                        -------------------------------
              (Address of principal executive office) (Zip code)

                                (704)-982-9184
                                --------------
                       (Registrant's telephone number)

                                      N/A
                                      ---
(Former name, former address and former fiscal year, if changed since last
                                    report)

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

As of February 12, 1999 there were issued and outstanding 4,208,724 shares of
the Registrant's common stock, no par value.
<PAGE>
 
                  SOUTH STREET FINANCIAL CORP. AND SUBSIDIARY

                                     INDEX

 PART I - FINANCIAL INFORMATION

     Item 1.  Financial Statements

     Consolidated statements of financial condition at December 31,
     1998 (Unaudited) and September 30, 1998                                   1
 
     Consolidated statements of income and comprehensive income for the
     three months ended December 31, 1998 and 1997   (Unaudited)               2
  
     Consolidated statements of cash flows for the three months
     ended December 31, 1998 and 1997 (Unaudited)                            3-4
 
     Notes to consolidated financial statements (Unaudited)                  5-7

Item 2.  Management's Discussion and Analysis of Financial Condition
          and Results of Operations                                         8-12
 
Item 3.  Quantitative and Qualitative disclosures about Market Risk           13
 
 
 PART II - OTHER INFORMATION
 
     Item 1.  Legal Proceedings                                               14
 
     Item 2.  Changes in Securities and Use of Proceeds                       14
 
     Item 3.  Defaults upon Senior Securities                                 14
 
     Item 4.  Submission of Matters to a Vote of Security Holders             14
 
     Item 5.  Other Information                                               14
 
     Item 6.  Exhibits and Reports on Form 8-K                                14

     Signatures                                                            15-16

 
<PAGE>
 
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION 
December 31,1998 and September 30, 1998 

<TABLE> 
<CAPTION> 
                                                                         DECEMBER 31,         September 30,
ASSETS                                                                      1998                  1998
------------------------------------------------------------------------------------------------------------
                                                                         (Unaudited)             (Note)*
<S>                                                                <C>                   <C> 
Cash and cash equivalents:                                            
     Noninterest-bearing deposits                                  $         3,469,000   $         2,891,000
     Interest-bearing deposits                                              19,652,000            26,895,000
     Federal Funds sold                                                      2,960,000             3,010,000
Securities held to maturity                                                 12,131,000            13,340,000
Securities available for sale                                               27,208,000            39,158,000
Federal Home Loan Bank stock                                                 1,707,000             1,707,000
Loans receivable, net                                                      110,623,000           110,550,000
Real estate acquired in settlement of loans                                     41,000                68,000
Real estate held for investment                                                813,000               960,000
Accrued interest receivable                                                  1,109,000             1,302,000
Office properties and equipment, net                                         1,156,000             1,106,000
Prepaid expenses and other assets                                            1,102,000               958,000
                                                                   -----------------------------------------
                   TOTAL ASSETS                                    $       181,971,000   $       201,945,000
                                                                   =========================================
                                                                      
LIABILITIES AND STOCKHOLDERS' EQUITY                                  
------------------------------------------------------------------------------------------------------------
Liabilities:                                                          
    Deposits                                                       $       148,755,000   $       148,444,000
    Note payable                                                                 -                18,000,000
    Advance payments by borrowers for taxes and insurance                      218,000               125,000
    Accounts payable and other liabilities                                   2,261,000             3,250,000
    Minority interest in Park Ridge Associates, LLC                             10,000                10,000
    Checks outstanding on disbursement account                                 248,000               561,000
                                                                   -----------------------------------------
                   TOTAL LIABILITIES                                       151,492,000           170,390,000
                                                                   -----------------------------------------
Stockholders' equity:
     Preferred stock, no par value, authorized 5,000,000 shares;
         no shares issued                                                        -                     - 
     Common stock, no par value, authorized 20,000,000 shares;                                           
         Issued 4,208,724 shares December 31, 1998 and                                                   
          4351,060                                                                                       
         Shares at September 30, 1998                                            -                     - 
     Additional paid-in capital                                             16,755,000            17,930,000
     Deferred Management Recognition Plan                                   (1,397,000)           (1,596,000)
     Accumulated other comprehensive income, unrealized gain
     (loss) on securities available for sale, net of tax                       (91,000)               26,000
     Unearned compensation                                                  (1,990,000)           (1,990,000)
     Unearned ESOP                                                          (3,842,000)           (4,080,000)
     Retained earnings, substantially restricted                            21,044,000            21,265,000
                                                                   -----------------------------------------
              TOTAL STOCKHOLDERS' EQUITY                                    30,479,000            31,555,000
                                                                   -----------------------------------------
              TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY           $       181,971,000   $       201,945,000
                                                                   =========================================
</TABLE>

*NOTE:  The Consolidated Statement of Financial Condition as of September 30,
        1998 has been taken from the audited financial statements of South
        Street Financial Corp. and Subsidiary at that date. 

See Notes to Consolidated Financial Statements.

                                       1
<PAGE>
 
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION AND COMPREHENSIVE INCOME
Three Months Ended December 31, 1998 and 1997

<TABLE>
<CAPTION>
                                                                                    1998                   1997
----------------------------------------------------------------------------------------------------------------------
                                                                                            (Unaudited)
<S>                                                                         <C>                   <C>  
INTEREST INCOME:                                                               
   Loans                                                                    $         2,280,000   $          2,396,000
   Mortgage-backed certificates                                                         328,000                526,000
   Investment securities                                                                422,000              1,106,000
   Other interest-bearing deposits                                                      230,000                263,000
                                                                            ------------------------------------------
       Total interest income                                                          3,260,000              4,291,000
Interest expense on deposits and borrowed funds                                       1,798,000              2,287,000
                                                                            ------------------------------------------
       NET INTEREST INCOME                                                            1,462,000              2,004,000
Provision for loan losses                                                                 -                      -
                                                                            ------------------------------------------
       NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES                            1,462,000              2,004,000
                                                                            ------------------------------------------
Noninterest income, net                                                                  29,000                 17,000
                                                                            ------------------------------------------
                                                                               
NONINTEREST EXPENSES:                                                          
   Compensation and benefits                                                            822,000              1,693,000
   Net occupancy                                                                         85,000                 60,000
   Federal insurance premium expenses                                                    22,000                 22,000
   Data processing                                                                       51,000                 51,000
   Other                                                                                226,000                196,000
                                                                            ------------------------------------------
                                                                                      1,206,000              2,022,000
                                                                            ------------------------------------------
       INCOME (LOSS) BEFORE INCOME TAXES                                                285,000                 (1,000)
Provision for income taxes                                                               92,000                  -
                                                                            ------------------------------------------
                                                                               
       NET INCOME (LOSS)                                                                193,000                 (1,000)
                                                                               
OTHER COMPREHENSIVE LOSS, NET OF TAX:                                          
    Unrealized holding losses arising during the period, net of tax                    (117,000)              (115,000)
    Less reclassification adjustment for losses included in net income,        
           net of tax                                                                    -                      13,000
                                                                            ------------------------------------------  
         Other comprehensive loss                                                      (117,000)              (102,000)
                                                                            ------------------------------------------  
                                                                               
      COMPREHENSIVE INCOME (LOSS)                                           $            76,000   $           (103,000)
                                                                            ==========================================
                                                                               
                                                                               
Basic earnings per share                                                    $              0.05   $              (0.02)
                                                                            ==========================================
Diluted earning per share                                                   $              0.05   $              (0.02)
                                                                            ==========================================
                                                                               
Dividends declared per share                                                $              0.10   $               0.10
                                                                            ==========================================
                                                                               
Average number of Basic shares outstanding                                            3,658,932              4,209,968
                                                                            ==========================================
                                                                               
Average number of Diluted shares outstanding                                          3,658,932              4,346,828
                                                                            ==========================================
</TABLE>
                                        
See Notes to Consolidated Financial Statements.

                                       2
<PAGE>
 
<TABLE>
<CAPTION>
                                                                           1998                       1997
-----------------------------------------------------------------------------------------------------------------
                                                                                     (Unaudited)
<S>                                                                    <C>                        <C> 
CASH FLOWS FROM OPERATING ACTIVITIES
 Net income                                                            $       193,000            $      (1,000)
 Adjustments to reconcile net income to net cash provided by                                          
    Operating activities:                                                                             
    Provision for loan losses                                                        -                        -
   Net accretion of premiums and discounts on securities                        (4,000)                 (46,000)
   Amortization of deferred loan fees                                         (147,000)                  52,000
   Provision for depreciation                                                   28,000                   29,000
   ESOP contribution                                                           142,000                  124,000
   Vesting of Management Recognition Plan                                      199,000                  998,000
   Deferred Income Taxes                                                        92,000                  340,000
   (Increase) Decrease in assets:                                                                    
      Accrued interest receivable                                              193,000                  285,000
      Prepaid and other assets                                                (144,000)                 113,000
  Increase (Decrease) in liabilities:                                                                 
      Accounts payable and other liabilities                                  (989,000)                (673,000)
       Interest payable                                                              -                 (111,000)
      Checks outstanding on disbursement                                                              
          Accounts                                                            (313,000)                  62,000
                                                                  ----------------------------------------------- 
         NET CASH PROVIDED BY OPERATING ACTIVITIES                            (750,000)               1,172,000
                                                                  ----------------------------------------------- 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES
  Purchases of securities available for sale                                (2,000,000)                       -
  Redemption of FHLB stock                                                           -                  543,000
  Proceeds from maturities and recalls of securities available                                                 
     for sale                                                               13,810,000               18,581,000
  Principal collected on securities held to maturity                         1,194,000                1,828,000
  Loan originations and principal payments on loans, net                       (61,000)                (871,000)
  Purchase of office properties and equipment                                  (79,000)                  (2,000)
  Purchase of real estate held for investment                                  (94,000)                       -
  Proceeds from sale of foreclosed real estate                                 241,000                        -
                                                                  ----------------------------------------------- 
        NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES                 13,011,000               20,079,000 
                                                                  -----------------------------------------------
                             (Continued)
</TABLE>

                                       3
<PAGE>
 
<TABLE>
<CAPTION>
                                                                           1998                    1997
-------------------------------------------------------------------------------------------------------------
<S>                                                                 <C>                     <C>       
CASH FLOWS FROM FINANCING ACTIVITIES
 Net increase in deposits                                           $        311,000        $       1,454,000
 Net increase in advance payments by borrowers for
  taxes and insurance                                                         93,000                  101,000  
 Principal payment received on ESOP note                                     238,000                   36,000 
 Repayment of short term debt                                            (18,000,000)                       - 
 Dividends paid to stockholders                                             (435,000)                (450,000)
 Retirement of stock purchased                                            (1,183,000)                       - 
 Repayment of Federal Home Loan Bank borrowings                                    -              (14,000,000) 
                                                                  -------------------------------------------
   NET CASH PROVIDED BY FINANCING ACTIVITIES                             (18,976,000)             (12,859,000)
                                                                  -------------------------------------------
 
   INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                       (6,715,000)               8,392,000      
Cash and cash equivalents:                                                                                      
 Beginning                                                                32,796,000               27,644,000     
                                                                  -------------------------------------------
 Ending                                                             $     26,081,000        $      36,036,000     
                                                                  ===========================================
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
 Cash and cash equivalents:
   Cash and short-term investments:
    Noninterest-bearing                                             $      3,469,000        $       2,430,000
    Interest-bearing                                                      19,652,000               18,676,000
     Federal Funds Sold                                                    2,960,000               14,930,000
                                                                  ===========================================
                                                                    $     26,081,000        $      36,036,000
                                                                  ===========================================
 
 
Net change in unrealized (gain) loss on securities available for
 sale, net of deferred taxes (credits)                              $       (117,000)       $        (102,000)
                                                                  ===========================================
</TABLE> 
 
 See Notes to Consolidated Financial Statements.

                                       4
<PAGE>
 
NOTE 1.   NATURE OF BUSINESS

Prior to October 2, 1996, Home Savings Bank of Albemarle, Inc., S.S.B. (the
"Bank") operated as a mutual North Carolina-chartered savings bank.  On October
2, 1996, the Bank converted from a North Carolina-chartered mutual savings bank
to a North Carolina-chartered savings bank (the "Conversion").  In connection
with the Conversion, all of the issued and outstanding capital stock of the Bank
was acquired by South Street Financial Corp., a North Carolina corporation (the
"Company") which was organized to become the holding company for the Bank.  At
that time, the Company had an initial public offering of its common stock, no
par value (the "Common Stock").

The Company is a bank holding company registered with the Board of Governors of
the Federal Reserve System (the "Federal Reserve") under the Bank Holding
Company Act of 1956, as amended (the "BHCA") and the savings bank holding
company laws of North Carolina.  The Company's office is located at 155 West
South Street, Albemarle, North Carolina.  The Company's activities consist of
investing the proceeds of its initial public offering which half of proceeds
were retained at the holding company level, holding the indebtedness outstanding
from the Home Savings Bank of Albemarle, Inc., SSB Employee Stock Ownership Plan
(the "ESOP") and owning the Bank.  The Company's principal sources of income are
earnings on its investments and interest payments received from the ESOP with
respect to the ESOP loan.  In addition, the Company will receive any dividends,
which are declared and paid by the Bank on its capital stock.

The Bank was originally chartered in 1911.  It has been a member of the Federal
Home Loan Bank ("FHLB") system since 1954 and its deposits are federally insured
up to allowable limits.  The Bank is engaged primarily in the business of
attracting retail deposits from the general public and using such deposits to
make mortgage loans secured by real estate.  The Bank makes mortgage loans
secured by residential real property, including one-to-four family residential
real estate loans, home equity line of credit loans and other subordinate lien
loans, loans secured by improved nonresidential real property, loans secured by
undeveloped real property and construction loans.  The Bank also makes a limited
number of loans, which are not secured by real property, such as loans secured
by savings accounts.  The Bank's primary source of revenue is interest income
from its lending activities.  The Bank's other major sources of revenue are
interest and dividend income from investments and mortgage backed securities,
interest income from its interest-bearing deposit balances in other depository
institutions and fee income from its lending and deposit activities.  The major
expenses of the Bank are interest on deposits and noninterest expenses such as
compensation and fringe benefits, federal deposit insurance premiums, data
processing expenses and branch occupancy and related expenses.

                                       5
<PAGE>
 
NOTE 2.   BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements (except for the
statement of financial condition at September 30, 1998, which is audited) have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Regulation S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (none of
which were other than normal recurring accruals) necessary for a fair
presentation of the financial position and results of operations for the periods
presented have been included.  The financial statements of the Company are
presented on a consolidated basis with those of Home Savings Bank.  The results
of operations for the three month period ended December 31, 1998 are not
necessarily indicative of the results of operations that may be expected for the
year ended September 30, 1999.

The accounting policies of the Company followed are as set forth in Note 1 of
the Notes to Consolidated Financial Statements in the 1998 annual report of the
Company.

NOTE 3.   EARNINGS PER SHARE

The Company's basic earnings per share for the three month period ended December
31, 1998 is based on net income earned divided by the weighted average number of
shares outstanding from the beginning of the three month period to the end of
the three month period and diluted earnings per share is adjusted for the
conversion, exercise or issuance of all potential common stock instruments.  For
purposes of this computation, the number of shares of common stock purchased by
the ESOP which have not been allocated to participant accounts are not assumed
to be outstanding.

NOTE 4.   DIVIDENDS DECLARED

On December 14, 1998, the Company's Board of Directors declared a dividend of $
 .10 a share for shareholders of record as of December 31, 1998 and payable on
January 13, 1999.  In addition, on December 14, 1998, the Board of Directors of
Home Savings declared an upstream dividend of $324,000 to the Company.

NOTE 5.   NOTES PAYABLE AND ADVANCES FROM FEDERAL HOME LOAN BANK

The note payable to Bankers' Bank in the amount of $18,000,000 was repaid on
October 1, 1998 and as of December 31, 1998 there are no outstanding notes or
Advances from the Federal Home Loan Bank.

                                       6
<PAGE>
 
NOTE 6.   STOCK OPTION PLAN AND THE BANK'S MANAGEMENT RECOGNITION PLAN

The Company's stockholders approved the Company's Stock Option Plan and the
Bank's Management Recognition Plan and Trust (the "MRP") on October 15, 1997.
The Stock Option Plan reserved for issuance up to 449,650 stock options to all
officers, directors, and employees at the time of the adoption either in the
form of incentive stock options or non-incentive stock options. The exercise
price of the stock options may not be less than the fair value of the Company's
common stock at date of grant. The options awarded to employees, which have not
yet been granted, will vest at the rate of 25% annually beginning at the date of
grant. Options granted to non-employee directors will vest immediately on the
date of grant. As permitted under the generally accepted accounting principles,
grants under the plan will be accounted for following the provisions of APB
Opinion No. 25 and its related interpretations. Accordingly, no compensation
cost will be recognized on the grant date of any options.

On December 4, 1998 the FASB announced that it will issue an exposure draft
during the first quarter of 1999 which will include interpretations of APB
Opinion No. 25 which are anticipated to be effective in September, 1999 and if
adopted will cover events that occur after December 15, 1998.  Under the
interpretations certain transactions should they occur would cause an entity to
adopt fair value accounting for stock.

The MRP reserved for issuance 179,860 shares of common stock to all officers,
directors, and employees at the time of adoption.  The Bank issued shares to
fund the MRP in October of 1997.  The restricted common stock under the MRP
vests at the rate of 25% annually beginning at the date of grant.

NOTE 7.   NEW ACCOUNTING STANDARD

The Company adopted Financial Accounting Standards Board Statement No. 130,
Reporting Comprehensive Income, during the quarter ended December 31, 1998.  The
Statement establishes standards for reporting and display of comprehensive
income and its components (revenues, expenses, gains and losses) in a full set
of general-purpose financial statements.  This Statement requires that all items
that are recognized under accounting standards as components of comprehensive
income be reported in a financial statement that is displayed with the same
prominence as other financial statements.

                                       7
<PAGE>
 
This Form 10Q contains certain forward-looking statements consisting of
estimates with respect to the financial condition, results of operations and
other business of the Company that are subject to various factors which could
cause actual results to differ materially from those estimates.  Factors, which
could influence the estimates, include changes in general and local market
conditions, legislative and regulatory conditions and an adverse interest rate
environment.

COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 1998 AND SEPTEMBER 30, 1998:

Total assets decreased by $20.0 million or 9.9%, to $181.9 million at December
31, 1998 from $201.9 million at September 30, 1998. The decrease in assets was
primarily attributable to a decrease in liquidity and investment securities,
which were used for repayment of the note payable to Bankers' Bank in the amount
of $18.0 million. The Company also repurchased 142,336 shares of the outstanding
common stock of the Company in the amount of $1.2 million.

Net loans receivable increased by $73,000 or 0.07% to $110.6 million at December
31, 1998 from $110.5 million at September 30, 1998.  Investment securities held
to maturity decreased $1.2 million or 9.1%, to $12.1 million at December 31,
1998 from $13.3 million at September 30, 1998. Likewise, investment securities
classified as available for sale decreased $11.9 million or 30.5%, to $27.2
million at December 31, 1998 from $39.2 million at September 30, 1998.  The
decrease was primarily due to the repayment of $18 million in borrowing from The
Bankers' Bank. The Bank had borrowings of $18.0 million outstanding at the end
of September 30, 1998.  The Bank has guaranteed the repayment of the ESOP's note
payable to the Company, which it incurred on October 2, 1996 in order to
purchase 359,720 shares of stock in the Company.  The Company's note receivable
from the ESOP totaling $3.8 million, net of $238,000 principal repayment made
during the three months ended December 31, 1998, is reported as a reduction of
stockholders' equity.  Retained earnings decreased by $221,000 to $21.0 million
at December 31, 1998, which is attributable to the Company's dividends accrued
for the three months ended December 31, 1998 in the amount of  $421,000, net of
$193,000 of net income  Additional paid-in capital, deferred MRP and unearned
compensation decreased by $976 thousand to $13.4 million at December 31, 1998
from $14.3 million at September 30, 1998.  The decrease was primarily
attributable to the repurchase of 142,336 shares of outstanding common stock in
the amount of $1.2 million.

As a North Carolina chartered stock savings bank, the Bank is required to meet
various capital standards established by federal and state banking agencies.  At
December 31, 1998 the Company's stockholders' equity amounted to $30.0 million,
or 16.7% of total assets and exceeds all regulatory capital requirements.

The Bank's level of nonperforming loans, defined as loans past due 90
days or more was $395,000 and $248,000  at December 31, 1998 and September 30,
1998, respectively.  During the three month periods ended December 31, 1998 and
1997, the Bank's level of nonperforming loans remained consistently low in
relation to prior periods and to total loans outstanding, and the Bank's charge-
offs of loans was minimal. Management determined based on their analysis that no
loan loss provisions were necessary during the first quarter of fiscal 1999.

                                       8
<PAGE>
 
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED DECEMBER 31, 1998 AND
1997:

GENERAL.  Net income for the three months ended December 31, 1998 was $193,000,
or $194,000 greater than the $(1,000) earned during the same period in 1997. As
discussed below, the increase in net income was primarily attributable to the
expensing of the "MRP" in the amount of $199,000 for the three month period
ended December 31, 1998 as compared to the $998,000 expensed for the same period
in 1997. This expense represents the three months accrual of the next 25%
vesting period.  The monthly recognition of the MRP expense over the next two
years will be $66,000.

INTEREST INCOME.  Interest income decreased by $1.0 million from $4.3 million
for the three months ended December 31, 1997 to $3.3 million for the three
months ended December 31, 1998. These decreases were attributable to the change
in the volume of interest-earning assets outstanding.

INTEREST EXPENSE.  Interest expense on deposits decreased by $489,000 from $2.3
million for the three months ended December 31, 1997 to $1.8 million for the
three months ended December 31, 1998. The decrease was primarily due to a
decrease in the rate of interest-bearing deposits for the three months ended
December 31, 1998 compared to the same period in 1997.  The Bank prices its
deposits to be at or near the top of the market because of its dependence on the
local market for funds availability.

NET INTEREST INCOME. Net interest income decreased by $542,000 from $2.0 million
for the three months ended December 31, 1997 to $1.5 million for the three
months ended December 31, 1998. This decrease resulted from the decrease in the
volume of interest-earning assets outstanding. The Bank's interest rate spread
decreased primarily because its deposits were more rate sensitive than its
interest-earning assets.

PROVISION FOR LOAN LOSSES.  There were no provisions for loan losses charged to
income during the three  months ended December 31, 1998. Provisions, which are
charged to operations, and  the  resulting  loan loss allowances are amounts the
Bank's management believes will be adequate to absorb  losses on existing loans
that may become uncollectible.

                                       9
<PAGE>
 
PROVISION FOR LOAN LOSSES. (CONTINUED)

Loans are charged off against the allowance when management believes that
collectibility is unlikely. The decision to increase or decrease the provision
and resulting allowances is based upon an evaluation of both prior loan loss
experience and other factors, such as changes in the nature and volume of the
loan portfolio, overall portfolio quality, and current economic conditions.  The
Bank's level of nonperforming loans has remained consistently low in relation to
prior periods and total loans outstanding, and the Bank's charge-offs of loans
during the three period ended December 31, 1998 and 1997 was minimal.

At December 31, 1998, the Bank's level of general valuation allowances for loan
losses amounted to $429,000, which management believes is adequate to absorb
potential losses in its loan portfolio.

NONINTEREST INCOME.   Noninterest income increased by $12,000 from $17,000 for
the three month period ended December 31, 1997 to $29,000 for the three month
period ended December 31, 1998.  This increase was attributable to a increase in
various small items during the three months ended December 31, 1998 as compared
to the same period in 1997.

NONINTEREST EXPENSE. Noninterest expense decreased by $816,000 from $2.0 million
for the three-month period ended December 31, 1997 to  $1.2 million for the
three-month period ended December 31, 1998.  The decrease in noninterest expense
is principally due to an decrease in benefits expense associated with the
establishment of an ESOP and the MRP as discussed below.

As a part of the conversion, the Company established an ESOP that acquired a
total of 359,720 shares of the stock offered in the conversion with funds
provided in the form of a loan from the Company.  The loan is expected to be
repaid over a fifteen-year period with funds provided by the Bank sufficient to
amortize the debt.  The expense associated with the ESOP is reported in
accordance with SOP 93-6 "Employers' Accounting for Employee Stock Ownership
Plans."

The MRP reserved for issuance 179,860 shares of common stock to all officers,
directors and employees on the adoption date of October 15, 1997.  The Bank
issued shares to fund the MRP in October of 1997.  The restricted common stock
under the MRP vests at the rate of 25% annually.  The expense recorded in the
three months ended December 31, 1998 represents three months accrual of the
yearly 25% vesting amount, while the expense for the three months ended December
31, 1997 represents immediate vesting of 25% of the MRP shares and three months
accrual of the next 25% amount.

CAPITAL RESOURCES AND LIQUIDITY:

The term "liquidity" generally refers to an organization's ability to generate
adequate amounts of funds to meet its needs for cash.  More specifically for
financial institutions, liquidity ensures that adequate funds are available to
meet deposit withdrawals, fund loan and capital expenditure commitments,
maintain reserve requirements, pay operating expenses, and provide funds for
debt service, dividends to stockholders, and other institutional commitments.
Funds are primarily provided through financial resources from operating
activities, expansion of the deposit base, borrowings, through the sale or
maturity of investments, the ability to raise equity capital, or maintenance of
shorter term interest-earning deposits.

                                       10
<PAGE>
 
CAPITAL RESOURCES AND LIQUIDITY (CONTINUED)

During the three month period ended December 31, 1998, cash and cash
equivalents, a significant source of liquidity, decreased by approximately $6.7
million.  This decrease is a direct result of the Company's repayment of $18.0
million in borrowings and the repurchase of the Company's common stock as
mentioned before.  Cash flow resulting from internal operating activities
provided for a decrease of $750,000 in cash during the three-month period ended
December 31, 1998.  Financing activities, principally the repayment of short-
term debt in the amount of $18.0 million provided for a decrease of $18.9
million in cash.  Investing activities, principally proceeds from maturities and
sales of securities of $15.0 million and purchase of securities totaling $2.0
million provided an additional $13.0 million.

As a state chartered stock savings bank, the Bank must meet certain liquidity
requirements that are established by the Administrator. The Bank's liquidity
ratio at December 31, 1998, as computed under such regulations, was considerably
in excess of such requirements. Given its excess liquidity and its ability to
borrow from the Federal Home Loan Bank of Atlanta, the Bank believes that it
will have sufficient funds available to meet anticipated future loan
commitments, unexpected deposit withdrawals, or other cash requirements.

The FDIC requires the Bank to have a minimum leverage ratio of Tier I Capital
(principally consisting of retained earnings and any common stockholders'
equity, less any intangible assets) to all assets of at least 3%, provided that
it receives the highest rating during the examination process. For institutions
that receive less than the highest rating, the Tier I capital requirement is 1%
to 2% above the stated minimum. The FDIC also requires the Bank to have a ratio
of total capital to risk-weighted assets of 8%, of which at least 4% must be in
the form of Tier I capital. The Administrator requires a net worth equal to at
least 5% of total assets. The Bank complied with all of the capital requirements
of both the FDIC and the Administrator at December 31, 1998.

The consolidated financial statements and accompanying footnotes have been
prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars without consideration for changes in the relative purchasing
power of money over time due to inflation.  The assets and liabilities of the
Company are primarily monetary in nature and changes in interest rates have a
greater impact on the Company's performance than do the effect of inflation.

YEAR 2000.

A lot of attention has been given to the impact that the year 2000 date change
will have on businesses, utilities and other organizations that rely on
computerized systems to help run their operations.  The year 2000 date change
can affect any system that uses computer software or computer chips including
automated equipment and machinery.  For example, many computer programs and
computer chips store the calendar year portion of the date as two digits rather
than four digits.  These software programs and chips record the year 1999 as
"99".  This approach works until the year 2000 when the "00" may be interpreted
as the year 1900 instead of the year 2000.

                                       11
<PAGE>
 
YEAR 2000 (CONTINUED)

Banks use computer systems to perform financial calculations, transfer funds,
record deposits and loan payments, run financial security systems and vaults and
a myriad of other functions. Because banks rely heavily on their computer
systems, the Federal Financial Institutions Examination Council ("FFIEC") has
placed significant emphasis on the problems surrounding the year 2000 issues and
has required financial institutions to document the assessment, testing and
corrections made to ready their computer systems and programs for the year 2000
date change. The FFIEC has strict regulations, guidelines, and milestones in
place that each FDIC insured financial institution must follow in order to
remain operational. The Company's board of directors has remained informed of
the Company's position and progress in its year 2000 project.

The Company's year 2000 project remains on schedule according to the guidelines
set forth by the FFIEC. The Company's most critical external exposure to year
2000 system problems is with its data processing provider, Fiserv. Fiserv
renovated its systems in June 1998 and is currently testing its remediation
efforts. Fiserv plans to have all of its systems year 2000 compliant by December
1998. Fiserv has responded to the Company that renovation of its program is
virtually complete. In the event that Fiserv is unable to make the necessary
corrections to its programs to accommodate the year 2000, the Company will
convert its data to one of the other Fiserv programs that is able to operate in
the 2000 environment.

In addition, the Company has contacted its major customers and vendors to
inquire about their progress in addressing the year 2000 problem and does not
believe that the problems of such customers and vendors will have a material
adverse effect on the Company or its operations. The Company will continue to
monitor the progress of these parties in addressing the year 2000 problem as the
new millennium approaches. Management estimates the cost to replace the computer
hardware and software with year 2000 compliant equipment to be approximately
$350,000 to $450,000, which will be installed during the second quarter of
fiscal 1999.

The year 2000 problems can affect the Company's operation in a number of ways
but the mission critical issue is maintaining customers' account information
including tracking deposits, interest accruals and loan payments. The Company is
dependent upon electricity, telephone lines, computer hardware and Fiserv's date
processing capability.

The Company is in contact with its electric utility and phone company, and
assurances have been given that no major problems exist and that both companies
will have all year 2000 problems addressed well before December 31, 1999. A new
telephone system will also be installed in the second quarter of fiscal 1999. If
the electric utility is unable to certify that its renovation is completed by
June 30, 1999, the Company will acquire portable generators with sufficient
capacity to run the system servers and at least one work station in each branch
office.

To prevent difficulties in the event there is an unforeseen interruption in
either telephone or electrical service when the year changes, the Company will
print hard copies of all account information. In addition, the Company will
download all account information into programs on the Company's hardware that
will allow bank personnel to extract customer information without regard to
outside sources.

                                       12
<PAGE>
 
ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK. One of the principal risks for the bank is interest rate
risk. One of the Bank's principal financial objectives is to achieve long-term
profitability while reducing its exposure to fluctuations in interest rates.
Historically, the Bank has been a mortgage lender so the loan portfolio
continues to have a large number of mortgage loans with maturities that are
considerably longer than for the deposits that fund those loans. Thus, an upward
movement in the market rate of interest would result is the cost of deposits
increasing at a faster rate than the rate on loans. The principal strategy of
the Bank over the past several years has been to emphasize the investment of
excess cash in short or intermediate term interest-earning assets, the
solicitation of transaction deposits accounts which are less sensitive to
changes in interest rates and can be repriced rapidly. The Company has not
experienced any substantial changes in its portfolio risk during the three-month
period ended December 31, 1998. See disclosures in the September 30, 1998 Form
10K. However, the Bank's interest rate spread has decreased slightly during the
three months ended December 31, 1998 due to a general economic decline in the
Bank's market area.

During 1998, the Bank formed a wholly owned subsidiary, South Street Development
Corporation ("SSDC") with a $1.8 million cash investment, SSDC then invested
$10,000 for a 50% interest in Park Ridge Associates, LLC ("Park Ridge"). An
outside individual owns the other 50% interest in Park Ridge. In June, 1998,
Park Ridge acquired 25.6 acres of prime real estate located within the city
limits of Albemarle, North Carolina. The joint venture was created to acquire
and develop the property into a premier residential subdivision. The upscale
subdivision consists of 30 building lots of which nine have been presold. As of
December 31, 1998, the project was two-thirds completed with an expected
completion date of March, 1999. The property will be marketed at that time.
There can be no assurances that the development will be completed by the
expected completion date, or that the Bank will be successful in recovering its
investment in the joint venture.

                                       13
<PAGE>
 
PART II.  OTHER INFORMATION

     Item 1.  Legal Proceedings

          The Company is not engaged in any legal proceedings at the present
          time. From time to time, the Bank is a party to legal proceedings
          within the normal course of business wherein it enforces its security
          interest in loans made by it, and other matters of a similar nature.

     Item 2.  Changes in Securities and Use of Proceeds

              Not applicable

     Item 3.  Defaults Upon Senior Securities

              Not applicable

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

              Not applicable

     Item 5.  Other Information

              Not applicable

     Item 6.  Exhibits and Reports on Form 8-K

              (a)   Exhibits

                    Exhibit (27) Financial Data Schedule

              (b)   Reports on Form 8-K
 
                    The Company has not filed any form 8-K for quarter ended
                    December 31, 1998 

                                       14
<PAGE>
 
SIGNATURES

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

                                       SOUTH STREET FINANCIAL CORP.

     Dated _______________________     By: /s/ Carl M. Hill
                                           ------------------------------
                                           Carl M. Hill
                                           President and Chief Executive Officer

     Dated _______________________     By: /s/ Christopher F. Cranford
                                           -------------------------------
                                           Christopher F. Cranford
                                           Treasurer and Controller

                                       15