Citizens South Banking 10-Q 2010 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2010

or

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to _____

Commission File Number 0-23971

Citizens South Banking Corporation

(Exact name of registrant as specified in its charter)

Delaware		54-2069979
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)
	519 South New Hope Road, Gastonia, NC 28054
	(Address of principal executive offices)
	(704) 868-5200
	(Registrant’s telephone number, including area code)

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

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

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

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

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)  Yes  [  ]   No [ x ] ­

As of August 13, 2010, there were 10,850,695 shares outstanding shares of the Registrant’s common stock, $0.01 par value.

Citizens South Banking Corporation

Index

Page

Item 1.	Financial Statements (unaudited)
	Consolidated Statements of Financial Condition - September 30, 2010 and December 31, 2009	1
	Consolidated Statements of Operations - Three and Nine MonthsEnded September 30, 2010 and 2009	2
	Consolidated Statements of Shareholders’ Equity -  Nine Months Ended September  30, 2010 and 2009	3
	Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2010 and 2009	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations	19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.	Controls and Procedures	32
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings	33
Item 1 A.	Risk Factors	33
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 6.	Exhibits	33
Signatures
Certifications

Part I.   Financial Information

Item 1.  Financial Statements

CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
	September 30, 2010			December 31, 2009
(Dollars in thousands, except per share)	(unaudited)
ASSETS
Cash and cash equivalents:
Cash and due from banks	$	16,792		$	8,925
Interest-earning bank balances		137,352			44,255
Cash and cash equivalents		154,144			53,180
Investment securities available for sale, at fair value		71,293			50,990
Investment securities held to maturity, at amortized cost		15,962			32,380
Federal Home Loan Bank stock, at cost		5,938			4,149
Presold loans in process of settlement		3,100			-
Loans:
Covered by FDIC loss-share agreements		160,327			-
Not covered by FDIC loss-share agreements		594,413			610,201
Allowance for loan losses		(10,752	)		(9,189	)
Net loans		743,988			601,012
Other real estate owned		11,740			5,067
Premises and equipment, net		23,972			15,436
FDIC loss share receivable		30,608			-
Accrued interest receivable		3,028			2,430
Bank-owned life insurance		18,107			17,522
Intangible assets		1,834			570
Other assets		3,844			8,796
Total assets	$	1,087,558		$	791,532
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Non-interest bearing demand	$	70,908		$	45,830
Interest-bearing demand		162,249			113,564
Money market accounts		147,269			118,687
Savings		17,021			10,584
Time deposits		468,339			320,680
Total deposits		865,786			609,345
Securities sold under repurchase agreements		9,785			8,970
Borrowings		101,236			97,629
Other liabilities		15,069			3,266
Total liabilities		991,876			719,210
Commitments and contingencies
Shareholders' Equity
Preferred stock, $0.01 par value, Authorized: 1,000,000 shares;
Issued and outstanding: 20,500 shares		20,651			20,589
Common stock, $0.01 par value, Authorized: 20,000,000 shares;
Issued: 11,011,414 and 9,062,727 shares respectively;
Outstanding: 10,964,146 and 7,526,854 shares respectively		124			91
Additional paid-in-capital		63,018			48,528
Retained earnings, substantially restricted		11,791			3,411
Accumulated other comprehensive income (loss)		98			(297	)
Total shareholders' equity		95,682			72,322
Total liabilities and shareholders' equity	$	1,087,558		$	791,532

See accompanying notes to consolidated financial statements.

1

CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
	Three Months Ended						Nine Months Ended
	September 30, 2010			September 30, 2009			September 30, 2010			September 30, 2009
(Dollars in thousands, except per share data)
Interest Income:
Interest and fees on loans	$	10,757		$	8,413		$	30,243		$	25,350
Investment securities:
Taxable interest income		620			775			1,914			2,703
Tax-exempt interest income		131			301			509			920
Other interest income		88			28			236			46
Total interest income		11,596			9,517			32,902			29,019
Interest Expense:
Demand deposits and savings		684			636			2,053			2,034
Time deposits		2,018			2,155			5,818			7,481
Securities sold under repurchase agreements		27			43			83			144
Borrowings		1,061			1,113			3,312			3,336
Total interest expense		3,790			3,947			11,266			12,995
Net interest income		7,806			5,570			21,636			16,024
Provision for loan losses		3,000			3,975			9,050			6,825
Net interest income after provision for loan losses		4,806			1,595			12,586			9,199
Noninterest Income:
Service charges on deposit accounts		1,132			859			2,893			2,428
Mortgage banking income		461			215			1,028			975
Commissions on sales of financial products		53			43			359			137
Income from bank-owned life insurance		196			202			627			570
Gain from acquisition		193			-			19,531			-
Gain on sale of investments, available for sale		305			973			349			1,281
Loss on sale of other assets		(185	)		(21	)		(451	)		(265	)
Other income		135			194			554			466
Total noninterest income		2,290			2,465			24,890			5,592
Noninterest Expense:
Compensation and benefits		3,774			2,570			10,069			7,588
Occupancy and equipment expense		732			632			2,454			1,958
Advertising and business development		80			115			233			303
Professional services		262			233			729			707
Data processing fees		179			130			513			389
FDIC deposit insurance		355			232			969			825
Amortization of intangible assets		154			81			372			243
Valuation adjustment on other real estate owned		393			-			1,088			175
Impairment on investment securities		-			333			-			547
Acquisition and integration expenses		141			-			1,022			-
Other expenses		1,711			903			3,968			2,670
Total noninterest expense		7,781			5,229			21,417			15,405
Income before income tax expense (benefit)		(685	)		(1,169	)		16,059			(614	)
Income tax expense (benefit)		(413	)		(672	)		5,680			(887	)
Net income (loss)		(272	)		(497	)		10,379			273
Dividends on preferred stock		256			262			769			774
Net income (loss) available to common shareholders	$	(528	)	$	(759	)	$	9,610		$	(501	)
Net income (loss) per common share:
Basic	$	(0.05	)	$	(0.10	)	$	1.04		$	(0.07	)
Diluted		(0.05	)		(0.10	)		1.04			(0.07	)
Weighted average common shares outstanding:
Basic		10,844,386			7,419,206			9,260,762			7,405,199
Diluted		10,844,386			7,419,206			9,260,762			7,405,199

See accompanying notes to consolidated financial statements.

2

CITIZENS SOUTH BANKING CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (unaudited)

								Retained			Accumulated
						Additional		Earnings			Other			Total
	Preferred			Common		Paid-in		Substantially			Comprehensive			Shareholders'
	Stock			Stock		Capital		Restricted			Income (Loss)			Equity
(Dollars in thousands)
Balances, January 1, 2009	$	20,507		$	91	$	48,009	$	36,088		$	25		$	104,720
Comprehensive results:
Net income		-			-		-		273			-			273
Other comprehensive results, net of tax		-			-		-		-			539			539
Accretion of discount on preferred stock		62			-		-		(62	)		-			-
Allocation from shares purchased with loan to ESOP		-			-		137		-			-			137
Vesting of Recognition and Retention Plan (RRP)		-			-		251		-			-			251
Stock-based compensation		-			-		79		-			-			79
Stock options exercised		-			-		20		(20	)		-			-
Preferred stock dividends		-			-		-		(774	)		-			(774	)
Cash dividends paid ($0.165 per common share)		-			-		-		(1,235	)		-			(1,235	)
															-
Balances, September 30, 2009	$	20,569		$	91	$	48,496	$	34,270		$	564		$	103,990
Balances, January 1, 2010	$	20,589		$	91	$	48,528	$	3,411		$	(297	)	$	72,322
Comprehensive results:
Net income		-			-		-		10,379			-			10,379
Other comprehensive results, net of tax		-			-		-		-			395			395
Issuance of 1,490,400 shares of common stock		-			15		5,745		-			-			5,760
Issuance of 8,280 shares of preferred stock		8,280			-		-		-			-			8,280
Conversion of 8,280 shares of preferred stock to 1,839,999 shares of common stock		(8,280	)		18		8,262		-			-			-
Accretion of discount on preferred stock		62			-		-		(62	)		-			-
Allocation from shares purchased with loan to ESOP		-			-		137		-			-			137
Vesting of RRP		-			-		272		-			-			272
Stock-based compensation		-			-		74		-			-			74
Preferred stock dividends		-			-		-		(769	)		-			(769	)
Cash dividends paid ($0.12 per common share)		-			-		-		(1,167	)		-			(1,167	)
															-
Balances, September 30, 2010	$	20,651		$	124	$	63,018	$	11,792		$	98		$	95,683

See accompanying notes to consolidated financial statements.

3

CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
	Nine Months Ended
	September 30, 2010			September 30, 2009
(Dollars in thousands)
Cash flows from operating activities:
Net income	$	10,379		$	273
Reconciliation of net income to net cash provided by operating activities:
Provision for loan losses		9,050			6,825
Depreciation of premises and equipment		934			785
Impairment of securities		-			547
Gain on sale of investment securities available-for-sale		(349	)		(1,281	)
Loss on sale of other assets		451			265
Gain on acquisition		(19,531	)		-
Valuation adjustment on other real estate owned		1,088			175
Net purchase accounting adjustments - discount accretion		652			-
Deferred loan origination fees		59			(23	)
Amortization of intangible assets		372			243
Allocation of shares to the ESOP		137			137
Stock-based compensation expense		74			79
Vesting of shares issued for the RRP		272			251
Decrease in accrued interest receivable		581			292
(Increase) decrease in other assets		6,171			(3,940	)
Increase (decrease) in other liabilities		3,752			(2,259	)
Net cash provided by operating activities		14,092			2,369
Cash flows from investing activities:
Net decrease in loans		30,469			4,567
Net increase in loans available for sale		(3,099	)		-
Proceeds from sales of securities available for sale		43,109			47,977
Proceeds from sales of premises and equipment		-			815
Proceeds from sales of other real estate owned		4,634			2,185
Proceeds from maturities/issuer calls of securities available for sale		20,076			15,911
Proceeds from maturities/issuer calls of securities held to maturity		30,015			-
Purchases of securities available for sale		(60,188	)		(32,183	)
Purchases of securities held to maturity		(13,597	)		(11,086	)
Net cash received in acquisition		95,058			-
Redemption of FHLB stock		458			644
Purchases of premises and equipment		(9,263	)		(135	)
Net cash provided by investment activities		137,672			28,695
Cash flows from financing activities:
Net increase (decrease) in deposits		(35,778	)		20,127
Cash dividends paid to common stockholders		(1,167	)		(1,235	)
Cash dividends paid to preferred stockholders		(769	)		(774	)
Issuance of common stock		14,040			-
Repayment of borrowed money		(27,162	)		(13,654	)
Increase (decrease) in advances from borrowers for insurance and taxes		36			(89	)
Net cash provided by (used in) financing activities		(50,800	)		4,375
Net increase in cash and cash equivalents		100,964			35,439
Cash and cash equivalents at beginning of year		53,180			10,057
Cash and cash equivalents at end of year	$	154,144		$	45,496
Supplemental non-cash investing activity:
Foreclosed loans transferred to other real estate owned	$	10,795		$	3,330

See accompanying notes to consolidated financial statements.

4

CITIZENS SOUTH BANKING CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  They do not include all of the information and footnotes required by such accounting principles for complete financial statements, and therefore should be read in conjunction with the audited consolidated financial statements and accompanying footnotes in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The consolidated balance sheet at December 31, 2009, was derived from the audited consolidated financial statements presented in the Company’s Annual Report on Form 10-K for the year ended D ecember 31, 2009.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period.  The more significant estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, other-than-temporary impairments on securities, and fair value of acquired loans.  Additional information regarding these estimates is presented in Part I. Item 2. of this report under the “Critical Accounting Policies” section.  Actual results could differ from those estimates.

In management’s opinion, the accompanying unaudited consolidated financial statements reflect all adjustments necessary for a fair presentation of the interim financial statements as of and for the three- and nine-month periods ended September 30, 2010 and 2009 and have been included as required by Regulation S-X Rule 10-01.  The accompanying unaudited consolidated financial statements include the accounts of Citizens South Banking Corporation (the “Company”) and its wholly-owned subsidiary, Citizens South Bank (the “Bank”).  All significant intercompany transactions have been eliminated in consolidation.  Certain amounts reported in prior periods have been reclassified to conform to the current presentation.  Such reclassifications had no effect on total assets, ne t income, or shareholders’ equity as previously reported.  Results for the three- and nine-month periods ended September 30, 2010, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2010.

Note 2 - Recent Accounting Pronouncements

A summary of the accounting policies followed by the Company may be found in Note 1 – Summary of Significant Accounting Policies in the 2009 Annual Report on Form 10-K filed with the SEC.  Updates to the significant accounting policies are made as new or revised accounting pronouncements are made. The following paragraphs update that information.

In January 2010, the Financial Accounting Standards Board (“FASB”) issued additional guidance under Account Standards Codification Topic 820, “Fair Value Measurements and Disclosures”, requiring improved disclosures of significant transfers in and out of fair value hierarchy levels, and the reasons for the transfers, and to present information about purchases, sales, issuances and settlements separately in the reconciliation of fair value measurements using significant unobservable inputs.  Certain additional disclosures are now required in interim and annual periods to discuss the inputs and valuation techniques used to measure fair value. The FASB’s objective is to improve these disclosures and increase the transparency in financial repo rting. The Company has applied the new disclosure requirements as of January 1, 2010.  Except for the additional disclosures about purchases, sales, issuances and settlements in the Level 3 reconciliation, this guidance will be effective for periods beginning after December 15, 2010.  The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

5

In February 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-09, Subsequent Events: Amendments to Certain Recognition and Disclosure Requirements.  The amendment removed the requirement to disclose the date through which subsequent events have been evaluated, and became effective immediately upon issuance and is to be applied prospectively.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2010, the FASB issued ASU No. 2010-18, Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset. The guidance provides that if loans meet the criteria to be accounted for within a pool, modification of one or more of these loans does not result in the removal of the modified loan from the pool even if the modification would otherwise be considered a troubled debt restructuring. The pool of assets in which the loan is included will continue to be considered for impairment.  The amendments do not apply to loans not meeting the criteria to be accounted for within a pool. These amendments are effective for modifications of loans accounted for within pools occurring in the first interim or annual period ending on or after July 15, 2010. The Company does not expect the adoption of this guidance to have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This guidance requires the Company to provide more information about the credit quality of its financing receivables, such as aging information, past due information, information regarding loans modified in a troubled debt restructuring and other credit quality indicators, in the disclosures to its financial statements.  Both new and existing disclosures must be disaggregated by portfolio segment or class.  The disaggregation of information is based on how the entity develops its allowance for credit losses and how it manages its credit exposure.  The required disclosures are effective for interi m and annual periods ending on or after December 15, 2010.  The Company will provide all required disclosures beginning with the Annual Report on Form 10-K for the year ended December 31, 2010.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to September 30, 2010. None of these new standards had or is expected to have a material impact on the Company’s consolidated financial statements.

Note 3 – FDIC-Assisted Acquisition

On March 19, 2010, Citizens South Bank, the wholly-owned subsidiary of Citizens South Banking Corporation, entered into a purchase and assumption agreement with the Federal Deposit Insurance Corporation (“FDIC”), as receiver for Bank of Hiawassee, to acquire substantially all of the assets and assume substantially all of the liabilities of Bank of Hiawassee (the “acquisition”). The Bank of Hiawassee was a Georgia state-chartered bank headquartered in Hiawassee, Georgia, and operated five full-service offices in the North Georgia area.  This acquisition extended the Bank’s geographic footprint outside of the Charlotte metropolitan area, providing geographic diversification for future loan and deposit growth.

The acquired loans, also referred to as “covered loans,” are covered by two loss-share agreements between the FDIC and the Bank, which afford the Bank significant protection against future loan losses.  Under these loss-share agreements, the FDIC will cover 80% of net loan losses up to $102 million and 95% of net loan losses that exceed $102 million.  The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans, five years for losses on all other loans and eight years for recoveries on all other loans. The Bank recorded an estimated receivable from the FDIC in the amount of $36.3 million, which represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.  New loans made after the acquisition date are not covered by the FDIC loss-share agreements.

The purchased assets and assumed liabilities were recorded at their respective acquisition date fair values.  Management engaged an independent third party to assist in determining the fair value of these acquired financial instruments.  These fair value determinations, which involved significant assumptions and judgment by management, are considered preliminary and may be adjusted for a period of one year after the acquisition as relevant information

6

becomes available regarding the estimated fair value on the date of acquisition. After applying purchase accounting adjustments to the acquired assets and liabilities, the Company recognized a $19.3 million pre-tax gain from the acquisition which was included as a component of noninterest income.  Citizens South Bank received a $33.0 million discount on the assets acquired and paid a $2.5 million, or 1%, deposit premium, resulting in net proceeds of $30.5 million to Citizens South Bank funded by the FDIC.   Also, as a part of this acquisition, the Company recorded a $1.6 million core deposit intangible that will be amortized over an eight-year period under the accelerated method. The operating results of Citizens South Banking Corporation for the three and nine month periods ended September 30, 2010, includes the results of the acquired assets and assumed liabilities from the date of acquisition.

A summary of the net assets received from the FDIC and the estimated fair value adjustments resulting in an initial after tax gain of $11.5 million are as follows:

	March 19, 2010
	(Dollars in thousands)
Cash payment from FDIC	$	66,400
Book value of net assets/liabilities assumed		(35,251	)
Fair value adjustments:
Loans		(46,702	)
FDIC indeminfication asset		36,301
Other real estate owned		(83	)
Core deposit intangible		1,637
Time deposits		(768	)
Borrowed money		(1,583	)
Other liabilities		(1,218	)
Deferred tax liability		(7,222	)
Net after tax gain on acquisition	$	11,511

7

The assets acquired and liabilities assumed in the acquisition are as follows:

	March 19, 2010
	(Dollars in thousands)
Assets Acquired
Cash and due from banks	$	95,058
Investment securities, available for sale		22,309
Loans		183,207
FDIC indemnification asset		36,301
Other real estate owned		1,076
Core deposit intangible		1,637
Other assets		3,741
Total assets acquired	$	343,329
Liabilities Assumed
Deposits	$	292,219
Borrowings		31,582
Deferred tax liabilities		7,222
Other liabilities		795
Total liabilities assumed	$	331,818
Net Assets Acquired	$	11,511

Note 4 – Issuance of Common and Preferred Stock

The Company entered into a Securities Purchase Agreement, as amended, effective as of March 17, 2010 (the “Purchase Agreement”), with accredited investors (collectively, the “Investors”), pursuant to which the Company raised, in the aggregate, approximately $15.0 million through direct sales to such Investors of equity securities of the Company (the “Private Placement”). The Private Placement was completed on March 17, 2010. Under the terms of the Purchase Agreement, the Investors purchased, in the aggregate, 1,490,400 shares of the Company’s common stock at a purchase price of $4.50 per share and 8,280 shares of a newly authorized series of the Company’s preferred stock, designated as Mandatorily Convertible Cumulative, Non-Voting Perpetual Preferred Stock, Series B (the “Series B Preferred Stock”) at a purchase price and liquidation preference of $1,000 per share. After the receipt of certain approvals, each share of the Series B Preferred Stock converted into the Company’s common stock effective June 29, 2010, at a conversion price of $4.50 per share of common stock. Upon conversion of the 8,280 shares of Series B Preferred Stock, 1,839,999 additional shares of the Company’s common stock were issued to the Investors.

Note 5 – Earnings per Common Share

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

8

The following is a reconciliation of the diluted earnings (loss) per share calculation for the three and nine months ended September 30, 2010 and 2009:

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2010			2009			2010		2009
	(Dollars in thousands, except per share amounts)
Net income (loss) available to common shareholders	$	(528	)	$	(759	)	$	9,610	$	(501	)
Basic EPS	$	(0.05	)	$	(0.10	)	$	1.04	$	(0.07	)
Shares used in the computation of basic EPS:
Weighted avg. number of shares outstanding		10,844,386			7,419,206			9,260,762		7,405,199
Incremental shares from assumed exercise of stock options and restricted stock		-			-			-		-
Weighted average number of shares   outstanding - diluted		10,844,386			7,419,206			9,260,762		7,405,199
Diluted EPS	$	(0.05	)	$	(0.10	)	$	1.04	$	(0.07	)

For the three- and nine-month periods ended September 30, 2010 and 2009, options to purchase 797,927 shares and 796,967 shares, respectively, were excluded from the calculation of diluted earnings per share because the option exercise price exceeded the average closing price of the associated shares of common stock during the respective periods.

9

Note 6 – Comprehensive Income

Comprehensive income is the change in the Company’s equity during the period from transactions and other events and circumstances from non-owner sources. Comprehensive income consists of net income and other comprehensive income. The Company’s other comprehensive income and accumulated other comprehensive income (loss) are comprised of unrealized gains and losses on certain investment securities. Information concerning the Company’s other comprehensive income for the three- and nine-month periods ended September 30, 2010 and 2009 is as follows:

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2010			2009			2010			2009
	(Dollars in thousands)						(Dollars in thousands)
Net income (loss)	$	(272	)	$	(497	)	$	10,379		$	273
Other comprehensive income:
Investment securities, available for sale:
Unrealized holding gains arising during period		422			2,176			992			2,158
Tax expense		(163	)		(839	)		(382	)		(832	)
Reclassification for realized gains included in net income		(305	)		(973	)		(349	)		(1,281	)
Tax benefit		118			375			135			494
Other comprehensive income		72			739			395			539
Total comprehensive income	$	(200	)	$	242		$	10,774		$	812

10

Note 7 – Investment Securities

The amortized cost, unrealized gains and losses, and estimated fair values of investment securities as of September 30, 2010 and December 31, 2009, are summarized as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated
	Cost		Gains		Losses		Fair Value
	(Dollars in thousands)
September 30, 2010
Available for sale:
U.S. Government Agency obligations	$	15,304	$	39	$	-	$	15,343
Municipal bonds		8,165		188		1		8,352
Mortgage-backed securities		44,500		355		10		44,845
Other securities		3,166		105		518		2,753
Subtotal		71,135		687		529		71,293
Held to maturity:
U.S. Government Agency obligations		6,484		62		-		6,546
Mortgage-backed securities		9,478		1,003		-		10,481
Subtotal		15,962		1,065		-		17,027
Total at September 30, 2010	$	87,097	$	1,752	$	529	$	88,320
			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated
	Cost		Gains		Losses		Fair Value
	(Dollars in thousands)
December 31, 2009
Available for sale:
U.S. Government Agency obligations	$	9,000	$	32	$	13	$	9,019
Municipal bonds		20,118		98		345		19,871
Mortgage-backed securities		19,258		216		115		19,359
Other securities		3,098		141		498		2,741
Subtotal		51,474		487		971		50,990
Held to maturity:
U.S. Government Agency obligations		26,464		84		305		26,243
Mortgage-backed securities		5,916		117		-		6,033
Subtotal		32,380		201		305		32,276
Total at December 31, 2009	$	83,854	$	688	$	1,276	$	83,266

The Bank pledges investment securities as collateral for public deposits.  These pledged investments totaled $15.6 million at December 31, 2009 and $31.7 million at September 30, 2010.

11

Note 8 - Loans

As referenced in Note 3 of this report, the Company acquired $183.2 million of loans, net of fair value adjustments of $46.7 million, in the acquisition of the Bank of Hiawassee.  The acquired loans are covered by loss share agreements between the FDIC and Citizens South Bank which affords Citizens South Bank significant protection against future loan losses.  Under the loss share agreements, the FDIC will cover 80% of loan losses up to $102 million and 95% of loan losses that exceed $102 million.  The Bank recorded an estimated receivable from the FDIC in the amount of $36.3 million, which represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.

For the nine-month period ended September 30, 2010, total loans increased by $144.5 million, or 23.7%, to $754.7 million.  These loans are comprised of $594.4 million of non-covered loans and $160.3 million of loans covered by the FDIC loss-share agreements.  The following is a summary of non-covered loans outstanding by category at the periods presented:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
Non-covered Loans:
One-to-four family residential	$	102,266	$	90,666
Construction		11,229		22,325
Multi-family residential		23,678		25,577
Commercial real estate		308,141		315,563
Commercial business		34,770		38,442
Consumer		114,795		117,473
Gross non-covered loans		594,879		610,046
Less:
Deferred loan fees, net and other items		466		(155	)
Net non-covered loans	$	594,413	$	610,201

The following is a summary of non-covered construction loans outstanding at the respective dates:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
Construction loans:
One-to-four family residential owner-occupied	$	524	$	1,109
One-to-four family residential speculative		5,889		10,911
Commercial		4,816		10,305
Total construction loans	$	11,229	$	22,325

12

        The following is a summary of non-covered commercial real estate loans at the periods presented:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
Commercial real estate loans:
Residential acquisition and development	$	26,094	$	35,694
Commercial land		40,620		40,191
Other commercial real estate		241,427		239,678
Total commercial real estate loans	$	308,141	$	315,563

Note 9 - Allowance for Loan Losses and Nonperforming Assets

The Company has established a systematic methodology for determining the adequacy of the allowance for loan losses.  This methodology is set forth in a formal policy and considers all non-covered loans in the portfolio.  Loans totaling $160.3 million that are covered under the FDIC loss-share agreements are not included in the Company’s evaluation of the adequacy of loan loss allowances since potential losses are covered up to at least 80% by the FDIC.  These covered loans were recorded at their estimated fair value at the time of the acquisition, resulting in a discount of $46.7 million, or 20.3%, of their contractual balance at the time of the acquisition.  The Company evaluates impairment of its non-covered residential mortgage and consumer loans on a collective basis, while non-covered commercial and construction loans are evaluated individually for impairment.  The Company identifies a non-covered loan as impaired when it is probable that principal and interest will not be collected according to the contractual terms of the loan agreement.  At September 30, 2010, management determined that non-covered impaired loans totaled $14.8 million, net of writedowns of $5.2 million.  These impaired loans also had specific valuation allowances totaling $1.1 million.  At December 31, 2009, management determined that non-covered impaired loans totaled $20.7 million, net of writedowns of $4.1 million. These impaired loans had valuation allowances totaling $2.3 million.

Specific allowances are established for certain individual non-covered loans that management considers impaired.  The remainder of the portfolio of non-covered loans is segmented into groups of loans with similar risk characteristics for evaluation and analysis. Management’s periodic evaluation of the allowance is consistently applied and based on inherent losses in the portfolio, past loan loss experience, risks inherent in the different types of loans, the estimated value of any underlying collateral, current economic conditions, the borrower’s financial position, and other relevant internal and external factors that may affect loan collectibility. The allowance for loan losses is increased by charging provisions for loan losses against income.  As of September 30, 2010, the allowance for loan losses was $10.8 million, or 1.81% of total non-covered loans.  Management believes that this amount meets the requirement for losses on loans that management considers to be impaired, for known losses, and for losses inherent in the remaining non-covered loan portfolio.  Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations.  A reconciliation of the allowance for loan losses is as follows:

		Three Months				Nine Months
		Ended September 30,				Ended September 30,
		2010		2009		2010		2009
		(Dollars in thousands)
Balance - Beginning of period		$	9,797	$	8,685	$	9,189	$	8,025
Add:	Provision for loan losses		3,000		3,975		9,050		6,825
	Loan recoveries		60		3		349		145
Less:	Loan charge-offs		2,105		3,164		7,836		5,496
Balance - End of period		$	10,752	$	9,499	$	10,752	$	9,499

13

The following is a summary of nonperforming assets at the periods presented:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
Nonaccrual loans - non-covered	$	19,652	$	8,135
Accruing non-covered loans past due 90 days or more		169		3,855
Non-covered nonperforming loans		19,821		11,990
Nonperforming loans - covered by FDIC loss-share		22,416		-
Total nonperforming loans		42,237		11,990
Other real estate owned - non-covered		8,557		5,067
Other real estate owned - covered by FDIC loss-share		3,183		-
Total nonperforming assets	$	53,977	$	17,057

The following is a detail of nonperforming non-covered loans at the periods presented:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
One-to-four family residential	$	2,068	$	898
Construction loans:
One-to-four family residential owner-occupied		-		-
One-to-four family residential speculative		163		1,048
Commercial real estate loans:
Residential acquisition and development		340		3,419
Commercial land		5,034		3,640
Other commercial real estate		9,566		1,841
Commercial business		720		140
Consumer		1,930		1,004
Total nonperforming non-covered loans	$	19,821	$	11,990

14

Note 10 – Deposits

Deposit balances for September 30, 2010 and December 31, 2009 are detailed as follows:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
Noninterest-bearing demand	$	70,908	$	45,830
Interest-bearing demand		162,249		113,564
Money market deposit		147,269		118,687
Savings		17,021		10,584
Time deposits		468,339		320,680
Total deposits	$	865,786	$	609,345

Note 11 – Commitments to Extend Credit

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

Commitments to extend credit (which includes both fixed and variable rates) are as follows:

	September 30, 2010		December 31, 2009
	(Dollars in thousands)
Loan commitments
Residential mortgage loans	$	17,284	$	12,560
Non-residential mortgage loans		5,924		13,656
Commercial loans		760		1,435
Consumer loans		1,034		849
Total loan commitments	$	25,002	$	28,500
Unused lines of credit
Commercial	$	16,641	$	18,448
Consumer		75,383		75,261
Total unused lines of credit	$	92,024	$	93,709
Undisbursed Construction Loan Proceeds	$	523	$	1,100

15

Note 12 – Fair Value Measurement

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures.  The Company has not elected the fair value option for liabilities.  Investment securities, available-for-sale, are recorded at fair value on a recurring basis.  Additionally, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans and other real estate owned.  These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting for these other assets.   A fair value hierarchy is used based on the markets in which the assets are traded and the reliability of the assumptions used to determine the fair value.  These levels are as follo ws:

Level 1:      Inputs to the valuation methodology are based on quoted prices in active markets for identical instruments.

Level 2:      Inputs to the valuation methodology are derived from readily available pricing sources for market transactions involving similar types of instruments in active markets.

Level 3:      Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Fair value measurements for assets where there exists limited or no observable market data and, therefore, are based primarily upon estimates, are often calculated based on the economic and competitive environment, the characteristics of the asset and other factors.  Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability.  Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.  The following is a description of valuation methodologies used for assets recorded at fair value. The determination of where an instrument fa lls in the hierarchy requires significant judgment.

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

Loans - The Company does not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market price and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2010, substantially all of the total im paired loans were evaluated based on the fair value of the collateral.  Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. Due to the ongoing real estate conditions resulting in inactive markets and limited and unreliable observable inputs, these impaired loans are classified as Level 3.  Presold loans in the process of settlement have a firm commitment from an independent party to purchase the loans in a timely manner are classified as Level 2.

 Other Real Estate Owned –Other real estate owned are adjusted to fair value upon transfer of the loans to other real estate owned. Subsequently, these assets are carried at the lower of carrying value or fair value.  Fair value is based upon a current appraised value less estimated disposition costs or other management estimate.  Due to the ongoing real estate conditions resulting in inactive markets and limited and unreliable observable inputs, these assets are classified as Level 3.

16

Assets Recorded at Fair Value on a Recurring Basis:

	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
September 30, 2010
Investment securities, available-for-sale	$	-	$	68,340	$	2,953	$	71,293
December 31, 2009
Investment securities, available-for-sale	$	-	$	48,049	$	2,941	$	50,990

Assets Recorded at Fair Value on a Nonrecurring Basis:

September 30, 2010
Presold loans in process of settlement	$	-	$	3,100	$	-	$	3,100
Impaired loans		-		-		14,776		14,776
Other real estate owned		-		-		11,740		11,740
December 31, 2009
Impaired loans	$	-	$	-	$	20,678	$	20,678
Other real estate owned		-		-		5,067		5,067

Note 13 - Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments.  For cash and due from banks, interest-earning bank balances, Federal Home Loan Bank stock, presold loans in process of settlement, accrued interest receivable, bank-owned life insurance, demand deposits, money market accounts, savings, and securities sold under repurchase agreements, fair value approximates carrying value due to their short-term nature.  The fair value for investment securities is based on quoted market prices, if available.  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 frequ ently is based on the carrying value reduced by an estimate of credit losses inherent in that portion of 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 time deposits are estimated by discounting cash flows from expected maturities using interest rates currently being offered for similar instruments.  The fair value for borrowings is based on discounted cash flows using current interest rates.  The fair value of off-balance sheet financial instruments is not considered to be material, so they are not included in the following table.

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. 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, or core deposit intangibles.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

17

The estimated fair valuesof financial instruments were as follows:

	September 30, 2010				December 31, 2009
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	16,792	$	16,792	$	8,925	$	8,925
Interest-earning bank balances		137,352		137,352		44,255		44,255
Investment securities		87,255		88,320		83,370		83,266
Federal Home Loan Bank stock		5,938		5,938		4,149		4,149
Presold loans in process of settlement		3,100		3,100		-		-
Net loans receivable		754,740		755,763		610,201		596,371
Accrued interest receivable		3,028		3,028		2,430		2,430
Bank-owned life insurance		18,107		18,107		17,522		17,522
Financial liabilities:
Demand deposits		233,157		233,157		159,394		159,394
Money market accounts		147,269		147,269		118,687		118,687
Savings		17,021		17,021		10,584		10,584
Time deposits		468,339		475,962		320,680		322,122
Securities sold under repurchase agreements		9,785		9,785		8,970		8,970
Borrowings		101,236		111,485		97,629		93,039

Note 14 – Subsequent Events

On October 18, 2010, the Board of Directors of the Company approved and declared a regular cash dividend of one cent ($0.01) per share of common stock and a 5% stock dividend to stockholders of record as of November 1, 2010, payable on November 15, 2010. The Company has paid cash dividends in each of the 50 quarters since the Company’s conversion to public ownership.

18

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

Forward Looking Statements

This report contains certain forward-looking statements that represent the Company's expectations or beliefs concerning future events. Such forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control.  These forward-looking statements are based on assumptions with respect to future business strategies and decisions that are subject to change based on changes in the economic and competitive environment in which we operate.  Forward-looking statements speak only as of the date they are made and the Company is under no duty to update these forward-looking statements or to reflect the occurrence of unanticipated events.  A number of factors could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements.   Factors that could cause such a difference include, but are not limited to, the timing and amount of revenues that may be recognized by the Company, changes in local or national economic trends, increased competition among depository and financial institutions, continuation of current revenue and expense trends (including trends affecting chargeoffs and provisions for loan losses), changes in interest rates, changes in the shape of the yield curve, changes in the level of non-performing assets and charge-offs, changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements, the level of future deposit premium assessments, our ability to raise capital to fund our growth plans or operations, the impact of the current governmental effort to restructure the U.S. financial and regulatory sy stem, the quality and composition of the Company’s investment portfolio, our ability to integrate the operations of Bank of Hiawassee, our fair value estimates and resulting gain on the acquisition of Bank of Hiawassee and adverse legal, regulatory or accounting changes. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on these statements.    Readers should carefully review the risk factors described in other documents the Company files from time to time with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K.

Executive Summary

Citizens South Banking Corporation is a Delaware corporation that owns all of the outstanding shares of common stock of Citizens South Bank (the "Bank").  The Company’s principal business activities are overseeing and directing the business of the Bank. The Company’s assets consist primarily of the outstanding capital stock of the Bank, deposits held at the Bank, and investment securities. The shares of common stock of the Company trade on the Nasdaq Global Market under the ticker symbol “CSBC.”  Citizens South Bank, which was chartered in 1904, is a federally chartered savings bank headquartered in Gastonia, North Carolina.  The Bank’s principal business activity is offering FDIC-insured deposits to local customers through its 21 branch offices and investing those deposit s, 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 the origination of loans secured by one-to-four family dwellings and sells uninsured financial products through a third party. The Bank’s results of operations are heavily dependent on net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings.  Results of operations are also materially affected by the Bank’s provision for loan losses, noninterest income, and noninterest expense.  Noninterest income includes fee income generated from deposit and loan accounts, mortgage banking fees, increases in the cash value of bank-owned life insurance policies, net gains (losses) from the sale of assets and other noninterest inc ome items.  The Bank’s noninterest expense primarily consists of compensation and employee benefits, occupancy expense, professional services, amortization of intangible assets, FDIC deposit insurance premiums and other noninterest expenses.  Results of operations are also significantly affected by local economic and competitive conditions, changes in interest rates, and actions of regulatory and governmental authorities.

The following discussion is provided to assist in understanding and evaluating the Company’s results of operations and financial condition and is designed to provide a general overview of the Company’s performance for the three- and nine-month periods ended September 30, 2010 and 2009.  Readers seeking a more in-depth analysis should read the detailed discussions below, as well as the consolidated financial statements and related notes.  Financial highlights for the comparable periods are presented in the following table.

19

Quarterly Financial Highlights (unaudited)	2010									2009
	At and For the Quarters Ended
	September 30			June 30			March 31			December 31			September 2009
(Dollars in thousands, except per share data)
Summary of Operations:
Interest income - taxable equivalent	$	11,675		$	12,308		$	9,210		$	9,387		$	9,656
Interest expense		3,790			4,083			3,393			3,531			3,947
Net interest income - taxable equivalent		7,885			8,225			5,817			5,856			5,709
Less: Taxable-equivalent adjustment		79			114			98			106			139
Net interest income		7,806			8,111			5,719			5,750			5,570
Provision for loan losses		3,000			3,000			3,050			4,155			3,975
Net interest income after loan loss provision		4,806			5,111			2,669			1,595			1,595
Noninterest income		2,290			2,415			20,185			2,381			2,465
Noninterest expense		7,781			7,279			6,356			34,867			5,229
Net income (loss) before income taxes		(685	)		247			16,498			(30,891	)		(1,169	)
Income tax expense (benefit)		(413	)		(108	)		6,201			(611	)		(672	)
Net income (loss)		(272	)		355			10,297			(30,280	)		(497	)
Dividends on preferred stock		256			257			257			259			262
Net income (loss) available to common shareholders	$	(528	)	$	98		$	10,040		$	(30,539	)	$	(759	)
Per Common Share Data:
Net income:
Basic	$	(0.05	)	$	0.01		$	1.29		$	(4.11	)	$	(0.10	)
Diluted		(0.05	)		0.01			1.29			(4.11	)		(0.10	)
Weighted average shares outstanding:
Basic		10,844,386			9,077,042			7,786,819			7,426,992			7,419,206
Diluted		10,844,386			9,077,042			7,786,819			7,426,992			7,419,206
End of period shares outstanding		10,964,146			10,965,941			9,125,942			7,526,854			7,526,854
Cash dividends declared	$	0.04		$	0.04		$	0.04		$	0.04		$	0.04
Book value		6.86			6.91			7.39			6.87			11.08
Tangible book value		6.70			6.73			7.16			6.80			7.06
End of Period Balances:
Total assets	$	1,087,558		$	1,077,431		$	1,132,652		$	791,532		$	820,608
Loans, net of deferred fees		754,740			776,234			787,643			610,201			616,793
Investment securities		87,255			97,678			100,161			83,370			90,174
Interest-earning assets		937,278			927,757			987,669			725,835			734,938
Deposits		865,786			853,526			884,127			609,345			606,614
Shareholders' equity		95,682			96,410			96,390			72,322			103,990
Quarterly Average Balances:
Total assets	$	1,080,680		$	1,105,788		$	873,418		$	823,608		$	831,268
Loans, net of deferred fees		767,381			780,209			599,826			610,568			624,112
Investment securities		91,425			100,501			89,020			87,061			94,673
Interest-earning assets		915,882			949,130			732,124			736,134			741,974
Deposits		853,902			859,408			614,007			605,608			609,243
Shareholders' equity		96,258			96,282			78,292			103,313			103,913
Financial Performance Ratios (annualized):
Return on average assets		-0.20	%		0.04	%		4.66	%		-14.71	%		-0.36	%
Return on average common equity		-2.77	%		0.56	%		73.21	%		-146.44	%		-3.61	%
Noninterest income to average total assets  (1)		0.85	%		0.87	%		9.24	%		1.16	%		1.19	%
Noninterest expense to average total assets (2)		2.88	%		2.63	%		2.91	%		16.93	%		2.52	%
Efficiency ratio  (1) (2)		76.47	%		68.41	%		24.44	%		423.30	%		63.97	%

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Quarterly Financial Highlights (unaudited)		2010									2009
		At and For the Quarters Ended
		September 30			June 30			March 31			December 31			September 2009
(Dollars in thousands, except per share data)
Net Interest Margin (annualized):
	Yield on earning assets		4.91	%		4.96	%		5.02	%		4.98	%		5.13	%
	Cost of funds		1.66	%		1.72	%		2.01	%		2.09	%		2.30	%
	Net Interest spread		3.25	%		3.24	%		3.01	%		2.89	%		2.83	%
	Net interest margin (taxable equivalent)		3.42	%		3.48	%		3.22	%		3.12	%		3.05	%
Credit Quality Information and Ratios:
	Past due loans (30-89 days) accruing - non-covered	$	6,602		$	10,145		$	7,003		$	10,224		$	10,860
	Past due loans - non-covered to total non-covered loans		1.11	%		1.68	%		1.15	%		1.68	%		1.76	%
	Past due loans (30-89 days) accruing - covered by FDIC loss-share (3)	$	8,701		$	5,257		$	11,030			-			-
	Past due loans - covered to total covered loans		5.43	%		3.07	%		6.09	%		-			-
	Allowance for loan losses - beginning of period	$	9,796		$	9,230		$	9,189		$	9,499		$	8,685
	Add:  Provision for loan losses		3,000			3,000			3,050			4,155			3,975
	Less:  Net charge-offs (NCOs)		2,044			2,434			3,009			4,465			3,161
	Allowance for loan losses - end of period		10,752			9,796			9,230			9,189			9,499
	Allowance for loan losses to total non-covered loans		1.81	%		1.62	%		1.52	%		1.51	%		1.54	%
	Net charge-offs to average non-covered loans (annualized)		1.36	%		1.61	%		1.98	%		2.93	%		2.04	%
	Nonperforming non-covered loans to non-covered loans		3.33	%		2.15	%		2.26	%		1.96	%		1.73	%
	Nonperforming non-covered assets to total assets		2.61	%		1.97	%		1.69	%		2.15	%		1.72	%
	Nonperforming non-covered assets to total non-covered loans and other real estate owned		4.71	%		3.46	%		3.12	%		2.77	%		2.28	%
	Nonperforming Assets (NPAs):
	Nonperforming loans:
	Non-covered loans:
	Residential	$	2,068		$	1,646		$	1,618		$	898		$	345
	Construction		163			896			443			1,048			1,554
	Acquisition and development		340			691			2,890			3,419			3,510
	Commercial land		5,034			3,252			6,148			3,640			1,884
	Other commercial real estate		9,566			4,127			1,422			1,841			2,197
	Commercial business		720			742			131			140			-
	Consumer		1,930			1,652			1,083			1,004			1,208
	Total non-covered nonperforming loans		19,821			13,006			13,735			11,990			10,698
	Total nonperforming loans covered by FDIC loss-share  (4)		22,416			24,924			15,846			-			-
	Other real estate owned - non-covered		8,557			8,239			5,386			5,067			3,444
	Other real estate owned - covered by FDIC loss-share		3,183			2,343			2,009			-			-
	Total nonperforming assets	$	53,977		$	48,512		$	36,976		$	17,057		$	14,142
Capital Ratios:
	Tangible common equity		6.74	%		6.86	%		5.78	%		6.47	%		6.72	%
	Total Risk-Based Capital (Bank only)		16.83	%		16.78	%		15.53	%		14.07	%		14.68	%
	Tier 1 Risk-Based Capital (Bank only)		15.58	%		15.52	%		14.47	%		12.98	%		13.53	%
	Tier 1 Total Capital (Bank only)		9.58	%		9.74	%		9.18	%		10.44	%		10.70	%

(1)  Includes the gain on acquisition of Bank of Hiawassee of $18.7 million for the quarter ended March 31, 2010. Subsequent adjustments in the amountsof $605,000 and $193,000 were made for the quarters ended June 30, 2010 and September 30, 2010, respectively.

(2)  Includes $29.6 million impairment of goodwill for the quarter ended December 31, 2009. Also includes acquisition and integration expenses of$787,000, $94,000, and $141,000 for the quarters ended March 31, 2010, June 30, 2010, and September 30, 2010, respectively.

(3)  The contractual balance of past due loans covered by FDIC loss-share agreements totaled $13.8 million, $6.4 million, and $14.8 millionat March 31, 2010, June 30, 2010, and September 30, 2010, respectively.

(4)  The contractual balance of nonperforming loans covered by FDIC loss-share agreements totaled $29.0 million, $35.4 million and $29.1 millionat March 31, 2010, June 30, 2010, and September 30, 2010, respectively.

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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, we have identified three policies as being more sensitive in terms of judgments and estimates – 1) the allowance for loan losses, 2) other-t han-temporary impairment of securities, and 3) the valuation of acquired loans.

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 non-covered loan portfolio at the measurement date. Management’s determination of the adequacy of the allowance is based on quarterly evaluations of the loan portfolio and other relevant factors.  However, this evaluation is inherently subjective, as it requires an estimate of the loss for each type of loan and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of the collateral. Management has established a systematic method for periodically evaluating the credit quality of the loan p ortfolio in order to establish an allowance for loan losses.  The methodology is set forth in a formal policy and includes a review of all loans in the portfolio on which full collectability may or may not be reasonably assured.  The loan review considers among other matters, the estimated fair value of the collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance.  Specific allowances are established for certain individual loans that management considers impaired.  The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis.  In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower, the term of the loan, general economic conditions, and in the case of a secured loan, the quality of the collateral.  We increase our allowance for loan losses by charging provisions for loan losses against our current period income.  Management’s periodic evaluation of the adequacy of the allowance is consistently applied and is based on our past loan loss experience, particular risks inherent in the different kinds of lending that we engage in, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, current economic conditions, and other relevant internal and external factors that affect loan collectability.  Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

Other-Than-Temporary Impairment of Securities.  On at least a quarterly basis management reviews all investment securities with significant declines in fair value for potential other-than-temporary impairment.  The fair value of the investment securities is obtained from an independent third party that specializes in investment security valuation and accounting.  Using this information, management evaluated the Company’s investment portfolio at September 30, 2010, and determined that all other unrealized losses were the direct result of temporary changes in interest rates and that such losses may be recovered in the foreseeable future.  The Company has the ability to hold these investments to maturity if necessary in order to recov er any temporary losses that may presently exist.  As a result, management did not consider any unrealized losses as “other-than-temporary” as of September 30, 2010.

Effective September 30, 2009, management evaluated the Company’s investment portfolio and determined that a $333,000 impairment on a $1.0 million trust preferred collateralized debt obligation was other-than-temporary. This investment was collateralized by trust preferred securities that were issued by a pool of 40 banks operating throughout the country.  Management determined that the impairment was other-than-temporary because 1) eight of the original 40 banks had defaulted or deferred on their payments; 2) the security, which had an original credit rating of “A-”, had been downgraded to “C”; and 3) the interest rate of LIBOR plus 105 basis points on this security was well below the current pricing for current bank capital.  Management determined that it was unlikely that the pric ing for bank capital would return to a level consistent with the pricing on the Company’s security in the foreseeable future.

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

Comparison of Financial Condition

Assets.  Total assets of the Company increased by $296.0 million, or 37.4%, from $791.5 million at December 31, 2009, to $1.1 billion at September 30, 2010.  This increase was primarily due to the acquisition of Bank of Hiawassee on March 19, 2010, which included $343.3 million in total assets at fair value as described in further detail in Note 3 of this quarterly report.

Total cash and cash equivalents, which include cash and due from banks and interest-earning bank balances, increased by $100.9 million from $53.2 million at December 31, 2009, to $154.1 million at September 30, 2010. This increase in cash and cash equivalents was primarily attributable to the $95.1 million of net cash received from the acquisition of Bank of Hiawassee.  The primary component of the cash received in the acquisition was the $66.4 million paid by the FDIC to the Company.  This payment by the FDIC represented the $35.3 million difference between the assets acquired and liabilities assumed and the Company’s $31.1 million negative bid, net of a 1% deposit premium paid, for the acquisition of Bank of Hiawassee. The remaining $28.7 million represents the existing cash and cash equivalents acquired fr om Bank of Hiawassee.  In addition, the Company sold $15.0 million of common stock during the nine-month period ended September 30, 2010.  This excess liquidity was being held in the Company’s account with the Federal Reserve Bank.  Management expects that a portion of these low-yielding deposits will be invested in higher-yielding loans and investments over the next several quarters.

During the nine-month period ended September 30, 2010, loans receivable increased by $144.5 million, or 23.7%, to $754.7 million.  This increase in loans was due to the acquisition of Bank of Hiawassee that included $160.3 million of loans at September 30, 2010.  Excluding the loans acquired in the Bank of Hiawassee transaction, the Company’s total loans decreased by $15.8 million.  This decrease was primarily due to reduced loan demand in the Company’s primary lending area and management’s efforts to reduce exposures in its construction and residential acquisition and development portfolios.  As a result of these efforts, speculative residential construction loans decreased by $5.0 million, or 46.0%, and residential acquisition and development loans decreased by $9.6 million, or 26.9%, during the nine month period ended September 30, 2010.  The Company remains focused on originating owner-occupied commercial real estate loans, commercial business loans and consumer loans to qualified borrowers.

A majority of the Company’s loans are to borrowers that are located in the Charlotte region.  While the economy in the Charlotte region has generally outperformed most other large metropolitan areas of the country during the ongoing economic slowdown, the economy in the Charlotte region remains sluggish.  As a result, the Company’s loan production slowed to $71.6 million during the first nine months of 2010 as compared to $104.2 million during the first nine months of 2009.  The Company’s expansion into the North Georgia market will allow us to geographically diversify our loan portfolio.  Although the North Georgia market has sustained significant decreases in real estate values over the past two years, management believes that when economic conditions normalize, this new mark et will be able to provide additional loan growth for the Company. While continued economic slowdowns in the local markets that we serve would have a negative impact on the Company’s ability to generate loan growth, management will seek to grow the loan portfolio in a prudent manner with an emphasis on borrowers that have a demonstrated capacity to meet their debt obligations, even in the current economic condition.

During the nine-month period ended September 30, 2010, investment securities increased by $3.9 million, or 4.6%, to $87.3 million.  The increase was due to the acquisition of Bank of Hiawassee which added $22.3 million of investment securities.  These acquired securities primarily consisted of U.S. Government agency bonds, U.S.

23

government issued mortgage-backed securities and municipal bonds, which are comparable to the types of investment securities that were in the Company’s existing investment portfolio.  During the nine-month period ended September 30, 2010, the Company sold $43.1 million of investment securities and experienced normal maturities and principal amortization of $50.1 million. Also, during the nine-month period, the Company purchased $73.8 million of investments securities, excluding the $22.3 million acquired from Bank of Hiawassee.  The sales of investment securities during the period were primarily due to a restructuring of the investment portfolio in an effort to reduce potential interest rate risk in a rising interest rate environment.  Management expects the investment portfolio to increase as a percentage of total assets over the next 12 months as the Bank’s excess liquidity is invested in higher-yielding assets.

Other real estate owned, which includes all properties acquired by the Company through foreclosure, totaled $11.7 million at September 30, 2010, compared to $5.1 million at December 31, 2009.   Of the $11.7 million of other real estate owned at September 30, 2010, $3.2 million is covered by FDIC loss-share agreements.  The remaining $8.5 million of non-covered other real estate owned is comprised of $2.1 million of one-to-four residential dwellings, $1.0 million of commercial real estate, and $5.4 million of developed residential lots and undeveloped land.  All foreclosed properties are written down to their estimated fair value (market value less estimated disposition costs) at acquisition and are located in the Bank’s primary lending area.  Management will continue to aggressively m arket foreclosed properties for a timely disposition.

During the nine-month period ended September 30, 2010, premises and equipment increased by $8.6 million to $24.0 million. As part of the acquisition of Bank of Hiawassee, the Company had an option to purchase the acquired bank’s existing four full-service offices and its operations center along with the existing premises and equipment which had a book balance of $10.8 million at the time of the acquisition.  The acquisition price was determined by an independent fair market valuation of the properties and the related furniture and equipment. The Company also assumed the lease for the Bank of Hiawassee’s fifth branch office.  During the third quarter of 2010, the Company acquired the existing four branch offices and related furniture and equipment for $8.7 million.  The Company did not acquire the acquired bank’s operations center.  Also during the first nine months of 2010, the Company recognized normal depreciation of $934,000 on its premises and equipment.  This depreciation was partly offset by the purchase of furniture and equipment for the Company’s new full-service leased office in Indian Trail, North Carolina.  This new office replaced the previous leased full-service office in Stallings, North Carolina

Liabilities. Total liabilities increased by $272.7 million, or 37.9%, from $719.2 million at December 31, 2009, to $991.9 million at September 30, 2010.  This increase was primarily due to the acquisition of Bank of Hiawassee that added total liabilities of $313.8 million at acquisition date.

During the first nine months of 2010, total deposits increased by $256.5 million, or 42.1%, to $865.8 million at September 30, 2010. This increase in deposits was primarily fueled by the $292.2 million in deposits assumed by Bank of Hiawassee during the first quarter of 2010.  Excluding the Bank of Hiawassee deposits, total core deposits increased by $14.6 million, or 5.1%.  This core deposit growth included a $7.6 million increase in demand deposits, a $6.8 million increase in money market accounts, and a $170,000 increase in savings accounts.   We believe our core deposit growth was partly due to a flight to safety as funds moved from weaker financial institutions and brokerage accounts as well as a continued emphasis on increasing the Company’s retail and business customers through employee incentive plans and enhanced treasury service products.  In addition to the growth in core deposits, the Company increased time deposits by $5.6 million, or 1.7%, excluding acquired deposits, during the nine-month period ended September 30, 2010.  The Company will continue to actively market the Company’s deposit products at pricing points that management believes to be profitable. Management has always focused on increasing deposits by building customer relationships and typically avoids growing deposits by offering the highest rates in the market. Deposits assumed in the acquisition decreased by $55.9 million.  This was largely due to a $29.3 million decrease in out-of-market internet deposits that are no longer being renewed.  These deposits totaled $8.6 million at September 30, 2110.

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While the Company does not actively solicit or obtain brokered deposits, this is an alternative funding source that may be used from time to time for additional loan growth or liquidity needs. At September 30, 2010, brokered deposits totaled $99,000.  This deposit was assumed in a previous acquisition.

During the first half of 2010 borrowed money increased by $3.6 million, or 3.7%, to $101.2 million at September 30, 2010.  This increase was primarily due to $31.6 million of Federal Home Loan Bank (“FHLB”) advances that were assumed in the Bank of Hiawassee acquisition.  The Company repaid $12.5 million of the FHLB advances assumed in the Bank of Hiawassee transaction in the second quarter of 2010.  Additional decreases in borrowed money were due to normal maturities during the period. The Company plans to use excess liquidity to repay these borrowings as they mature.  From time to time additional borrowed money may be used to fund additional loan growth, or to purchase investment securities.

Shareholders’ Equity.  Total shareholders’ equity increased by $23.4 million, or 32.3%, from $72.3 million at December 31, 2009, to $95.7 million at September 30, 2010.  This increase was primarily due to net income of $9.6 million during the first nine months of 2010 and the issuance of $14.0 million of common stock net of issuance costs. These increases were partly offset by the payment of $1.2 million in cash dividends on common stock.

Comparison of Results of Operations for the Three Months Ended September 30, 2010 and 2009

General.  Net loss available to common stockholders for the three months ended September 30, 2010, amounted to $528,000, or ($0.05) per diluted share, as compared to net loss available to common stockholders of $759,000, or ($0.10) per diluted share, for the three months ended September 30, 2009.  The decrease in net loss was largely related to the acquisition of Bank of Hiawassee which contributed to a $2.2 million, or 40.1%, increase in net interest income and a $193,000 pre-tax gain on the acquisition of Bank of Hiawassee.  Partly offsetting this increased level of income was a $2.6 million, or 48.8%, increase in noninterest expenses resulting largely from operating the Ba nk of Hiawassee offices and increased collection and credit costs.

Net interest income.Net interest income increased by $2.2 million, or 40.1%, to $7.8 million for the third quarter of 2010 as compared to $5.6 million for the third quarter of 2009. The Company’s net interest margin increased by 37 basis points to 3.42% for the quarter ended September 30, 2010, compared to 3.05% for the quarter ended September 30, 2009.  This increase in the net interest margin was the result of the cost of funds falling at a faster rate than the yield on assets. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, the Federal Reserve Board’s action to lower short-term interest rates by 200 basis points in the fourth quarter of 2008 had a more pronounced negative impact in the first three months following the decrease.  The short-term negative effects of this decrease in short-term interest rates have been mostly offset by time deposits that matured over the next 12 months and repriced at a lower cost to the Company.

Interest income increased by $2.1 million, or 22.1%, to $11.6 million for the third quarter of 2010, primarily as a result of the acquisition of Bank of Hiawassee which included $183.2 million of loans and $22.3 of investment securities. As a result, average interest-earning assets increased by $173.9 million during the comparable quarters to $915.9 million for the third quarter of 2010.  The positive effects of the increase in interest-earning assets was partly offset by a 22 basis point decrease in the average yield on earning assets during the respective periods to 4.91% for the quarter ended September 30, 2010. The decrease in yield was largely due to lower market rates and higher levels of lower-yielding liquid assets held during the third quarter of 2010.

Interest expense decreased by $157,000, or 4.0%, for the comparable periods to $3.8 million for the third quarter of 2010.  This decrease in interest expense was largely due to lower market interest rates, which resulted in a 64 basis point decrease in the average cost of funds to 1.66% for the quarter ended September 30, 2010.  The decrease in cost of funds offset the $222.1 million increase in the average interest-bearing liabilities to $900.1 million for the third quarter of 2010.  This change in interest-bearing liabilities included a $218.3 million increase in average interest-bearing deposits and a $3.9 increase in average borrowings, largely due to the acquisition.

25

Provision for loan losses.  Due to continued weakness in the local economy and an increase in nonperforming assets, the Company’s provision for loan losses amounted to $3.0 million for the third quarter of 2010 compared to $4.0 million for the third quarter of 2009.  As a result, the allowance for loan losses was $10.8 million, or 1.81% of total non-covered loans, as of September 30, 2010, compared to $9.5 million, or 1.54% of total loans, as of September 30, 2009.  While the Company’s credit quality continues to compare favorably with Southeast peer banks, the continued decline in local economic conditions has resulted in an upward trend in the Company’s level of nonperforming loans.   The Company ’s ratio of nonperforming non-covered assets to total assets increased from 1.72% at September 30, 2009, to 2.61% at September 30, 2010. A substantial portion of the Company’s nonperforming non-covered loans at September 30, 2010, was secured by real estate located in the Company’s normal lending market.  Net chargeoffs of non-covered loans totaled $2.0 million, or 1.36% of average non-covered loans annualized, during the third quarter of 2010 compared to $3.2 million, or 2.04% of average non-covered loans, during the third quarter of 2009. Management expects that the Company will continue to experience larger than normal loan loss provisions for the next several quarters.

Noninterest income.  Noninterest income decreased by $175,000 to $2.3 million for the three months ended September 30, 2010, as compared to $2.5 million for the three months ended September 30, 2009. The following table presents the detail for the three-month periods ending September 30, 2010, and September 30, 2009.

	Three Months Ended
	September 30, 2010			September 30, 2009			Variance
	(Dollars in thousands)
Noninterest income:
Service charges on deposit accounts	$	1,132		$	859		$	273
Mortgage banking income		461			215			246
Commissions on sales of financial products		53			43			10
Income from bank-owned life insurance		196			202			(6	)
Gain from acquisition		193			-			193
Gain on sale of investments, available for sale		305			973			(668	)
Loss on sale of other assets		(185	)		(21	)		(164	)
Other income		135			194			(59	)
Total noninterest income	$	2,290		$	2,465		$	(175	)

         Most of the increases in noninterest income were largely attributable to the acquisition of Bank of Hiawassee.  Service charges on deposit accounts were higher due to the increased number of demand deposit accounts which generate monthly service charges and non-sufficient (“NSFs”) funds fees on overdrafts. However, recent legislation limiting the assessment of NSF fees from overdrafts generated from debit cards beginning in the third quarter of 2010 will have an adverse impact on future fee income on deposit accounts.  The Company is working to lessen the negative impact of this legislation by asking customers to “opt-in” to allowing overdrafts on their debit cards.  Mortgage banking income was higher in the third quarter of 2010 due to increased origination activity arising from substantial decreases in long-term residential loan interest rates in 2010. Commissions on sales of financial products were higher largely due to increased activity.  Income from bank-owned life insurance decreased slightly due to decreased market rates.  The gain on acquisition was an adjustment to the initial $18.7 million gain that was booked in the first quarter of 2010 as a result of the acquisition of Bank of Hiawassee. This gain may be adjusted for a period of up to one year from the acquisition date as additional information about the fair value of the assets acquired and liabilities assumed is received. The gain on sale of investments was lower during the third quarter of 2010, due to the fact that there were fewer investments sold at a gain as compared to the third quarter of 2009.  During the third quarter of 2010, the Company sold $21.3 in investment securities compared to the sale of $26.4 million in investment securities during the third quarter of 2009.  These sales were primarily for the purpose of short ening the duration of the investment portfolio and reduce the adverse effects on rising rates on the Company’s equity position.  The loss on sale of other assets was higher due to increased losses from sale of foreclosed properties.  Other income decreased

26

primarily due to a decrease in the fair value adjustment on deferred compensation assets, which is directly offset by a corresponding decrease in noninterest expense, resulting in no net impact on earnings.

Noninterest expense. Noninterest expense increased by $2.6 million, or 48.8%, to $7.8 million for the quarter ended September 30, 2010.  The following table presents the detail of noninterest expense for the three-month periods ending September 30, 2010 and September 30, 2009.

			Three Months Ended
			September 30, 2010		September 30, 2009		Variance
			(Dollars in thousands)
Noninterest Expense:
	Compensation and benefits		$	3,774	$	2,570	$	1,204
	Occupancy and equipment expense			732		632		100
	Advertising and business development			80		115		(35	)
	Professional services			262		233		29
	Data processing fees			179		130		49
	FDIC deposit insurance			355		232		123
	Amortization of intangible assets			154		81		73
	Valuation adjustment on other real estate owned			393		-		393
	Impairment on investment securities			-		333		(333	)
	Acquisition and integration expenses			141		-		141
	Other expenses			1,711		903		808
		Total noninterest expense	$	7,781	$	5,229	$	2,552

The primary reason for the increases in noninterest expense was the acquisition and integration of Bank of Hiawassee.  Compensation and benefits increased due to the increased number of employees resulting from the Bank of Hiawassee acquisition.  The Company consolidated the data processing and back office functions of the Bank of Hiawassee into the existing Citizens South Bank systems during the third quarter of 2010.  This resulted in a reduction of employees during the third quarter of 2010.  Occupancy and equipment expense also increased due to the acquisition of Bank of Hiawassee which added five branch offices and an operations center.  The Company purchased the existing branch offices and related equipment from the FDIC during the third quarter of 2010.  The Company di d not purchase the operations center which was vacated in the third quarter of 2010. Data processing increased due to the operation of two separate data processing systems resulting from the acquisition.  The acquired data processing system was converted into the existing data processing system in the third quarter of 2010.  FDIC deposit insurance increased during the third quarter of 2010 due to the higher insured deposit balances resulting from the acquisition. Amortization of intangible assets was higher due to the amortization expense related to the $1.6 million core deposit intangible that was created as a result of the acquisition.  This intangible asset is being amortized over an eight-year period using the accelerated method.  The increased number of foreclosed properties and the lower real estate values resulted in the increased valuation adjustment on other real estate owned.  During the quarter ended September 30, 2009, management determined that t here was a $333,000 other-than-temporary impairment on a trust preferred security.  This security had a book balance of $13,000 at September 30, 2010.  Management determined that there were no other-than-temporary impairments on investment securities for the quarter ended September 30, 2010. Acquisition and integration expenses were related to costs associated with the Bank of Hiawassee acquisition.  Other expenses increased primarily as a result of higher collection costs and expenses associated with the Company’s other real estate owned.  These expenses include the payment of delinquent taxes, insurance, and maintenance.

Income taxes. The Company recognized an income tax benefit of $413,000 for the quarter ended September 30, 2010, compared to a benefit of $672,000 for the quarter ended September 30, 2009.  The decrease in the benefit was largely due to the lower pre-tax losses for the third quarter of 2010 compared to the third quarter of 2009.  Also, a

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smaller portion of the Company’s income was generated from tax-advantaged sources.  The Company generates nontaxable income from interest earned on bank-qualified municipal securities and loans and increases in cash value on bank-owned life insurance policies in order to reduce its overall tax burden.  However, as the Company continues to increase the amount of income derived from interest income on loans and fee income on loans and deposits, the effective tax rate will increase.

Comparison of Results of Operations for the Nine Months Ended September 30, 2010 and 2009

General.  Net income available to common stockholders for the nine months ended September 30, 2010, amounted to $9.6 million, or $1.04 per diluted share, as compared to a net loss available to common stockholders of $501,000, or ($0.07) per diluted share, for the nine months ended September 30, 2009.  This increase was largely due to a $19.5 million pre-tax gain on the acquisition of Bank of Hiawassee, which resulted in an after-tax gain of $12.0 million for the first nine months of 2010.  Partly offsetting this gain was a $2.2 million increase in the loan loss provision arising as a result of a slowing local economy and $1.0 million of expenses related to the acquisition and integration of the Bank of Hiawassee acquisition.  Also, the results of operations include the acquired assets and assumed liabilities of Bank of Hiawassee following the March 19, 2010, acquisition date.

Net interest income.Net interest income increased by $5.6 million, or 35.0%, to $21.6 million for the first nine months of 2010 as compared to $16.0 million for the first nine months of 2009. The Company’s net interest margin increased by 44 basis points to 3.39% for the nine months ended September 30, 2010, compared to 2.95% for the nine months ended September 30, 2009.  This increase in the net interest margin was the result of the cost of funds falling at a faster rate than the yield on assets. While the Company maintains a relatively neutral interest rate risk position on a cumulative one-year basis, the Federal Reserve Board’s action to lower short-term interest rates by 200 basis points in the fourth quarter of 2008 had a more pronounced negative impact in the first three months following the decrease.  The short-term negative effects of this decrease in short-term interest rates have been mostly offset by time deposits that matured over the next 12 months and repriced at a lower cost to the Company.

Interest income increased by $3.9 million, or 13.4%, to $32.9 million for the first nine months of 2010, primarily as a result of the increased interest-earning assets acquired in the Bank of Hiawassee transaction which was partly offset by a decrease in short-term market interest rates.  The Company’s average interest-earning assets increased by $121.1 million, or 16.3%, to $865.7 million largely due to the acquisition.  Partly offsetting the effects of the increase in average interest-earning assets, the Company’s average yield on interest-earning assets decreased by 28 basis points over the comparable periods to 4.97% for the nine months ended September 30, 2010.

Interest expense decreased by $1.7 million, or 13.3%, for the comparable periods to $11.3 million for the first nine months of 2010.  This decrease in interest expense was largely due to lower market interest rates, which resulted in a 78 basis point decrease in the average cost of funds to 1.80% for the nine months ended September 30, 2010.  Partly offsetting the positive effects of lower cost of funds, the Company’s average interest-bearing liabilities increased by $153.7 million, or 22.7%, to $832.2 million for the nine months ended September 30, 2010. Average interest-bearing liabilities increased primarily as a result of the acquisition.

Provision for loan losses.  Due to the general weakness in the local economy and an increase in nonperforming assets, the Company increased its provision for loan losses to $9.1 million for the first nine months of 2010 compared to $6.8 million for the first nine months of 2009.  As a result, the allowance for loan losses was $10.8 million, or 1.81% of total loans, as of September 30, 2010, compared to $9.5 million, or 1.54% of total loans, as of September 30, 2009.  While the Company’s credit quality continues to compare favorably with industry peers, the continued decline in local economic conditions has resulted in an upward trend in the Company’s loan delinquency ratios over the past 12 months.  The Compa ny’s ratio of nonperforming non-covered assets to total assets increased from 1.72% at September 30, 2009, to 2.61% at September 30, 2010. A substantial portion of the Company’s nonperforming non-covered loans at September 30, 2010, was secured by real estate located in the Company’s normal lending market.  Net chargeoffs of non-covered loans totaled $7.5 million, or 1.65% of average non-covered loans annualized, during the first nine months of 2010 compared to $5.4 million, or 1.13% of average loans, during the first nine months of

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2009.  Management expects that the Company will continue to experience larger than normal loan loss provisions for the next several quarters.

Noninterest income.  Noninterest income increased by $19.3 million to $24.9 million for the nine months ended September 30, 2010, as compared to $5.6 million for the nine months ended September 30, 2009. The following table presents the detail of noninterest income for the nine-month periods ending September 30, 2010 and September 30, 2009.

			Nine Months Ended
			September 30, 2010			September 30, 2009			Variance
			(Dollars in thousands)
Noninterest income:
	Service charges on deposit accounts		$	2,893		$	2,428		$	465
	Mortgage banking income			1,028			975			53
	Commissions on sales of financial products			359			137			222
	Income from bank-owned life insurance			627			570			57
	Gain from acquisition			19,531			0			19,531
	Gain on sale of investments, available for sale			349			1,281			(932	)
	Loss on sale of other assets			(451	)		(265	)		(186	)
	Other income			554			466			88
		Total noninterest income	$	24,890		$	5,592		$	19,298

The increases in noninterest income were largely attributable to the acquisition of Bank of Hiawassee.  Service charges on deposit accounts were higher due to the increased number of demand deposit accounts which generate monthly service charges and non-sufficient (“NSFs”) funds fees on overdrafts. However, recent legislation limiting the assessment of NSF fees from overdrafts generated from debit cards became effective in the second quarter of 2010.  The effect of this legislation has had a minor adverse impact on future fee income on deposit accounts.  The Company has worked to lessen the negative impact of this legislation by asking customers to “opt-in” to allowing overdrafts on their debit cards.  Mortgage banking income was higher during the first nine months of 201 0 compared to the first nine months of 2009.  This was largely due to decreases in long-term mortgage interest rates in 2010 that resulted in increased mortgage activity and fee income. Commissions on sales of financial products were higher largely due to increased activity and additional fees generated from Bank of Hiawassee.  Income from bank-owned life insurance increased due to improved performance of the life insurance policies.  The gain on acquisition was due to the acquisition of Bank of Hiawassee in the first quarter of 2010.  This gain may be adjusted for a period of up to one year from the acquisition date as additional information about the fair value of the assets acquired and liabilities assumed is received. The gain on sale of investments was lower during the first nine months of 2010 due to the fact that the investments sold during the first nine months of 2009 had larger gains than those investment securities sold during the first nine months of 2010.& #160; During the first nine months of 2010, the Company sold $43.1 million of investment securities compared to the sale of $48.0 million in investment securities during the first nine months of 2009.  These sales were primarily for the purpose of shortening the duration of the investment portfolio and reduce the adverse effects on rising rates on the Company’s equity position.  Other income increased primarily due to an increase in the fair value adjustment on deferred compensation assets, which is directly offset by a corresponding decrease in noninterest expense, resulting in no net impact on earnings and additional income generated from the Bank of Hiawassee.

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Noninterest expense.Noninterest expense increased by $6.0 million, or 39.0%, to $21.4 million for the nine months ended September 30, 2010.  The following table presents the detail of noninterest expenses for the nine months ended September 30, 2010 and September 30, 2009.

			Nine Months Ended
			September 30, 2010		September 30, 2009		Variance
			(Dollars in thousands)
Noninterest Expense:
	Compensation and benefits		$	10,069	$	7,588	$	2,481
	Occupancy and equipment expense			2,454		1,958		496
	Advertising and business development			233		303		(70	)
	Professional services			729		707		22
	Data processing fees			513		389		124
	FDIC deposit insurance			969		825		144
	Amortization of intangible assets			372		243		129
	Valuation adjustment on other real estate owned			1,088		175		913
	Impairment on investment securities			-		547		(547	)
	Acquisition and integration expenses			1,022		-		1,022
	Other expenses			3,968		2,670		1,298
		Total noninterest expense	$	21,417	$	15,405	$	6,012

The primary reason for the increases in noninterest expense was the acquisition and integration of Bank of Hiawassee.  Compensation and benefits increased due to the increased number of employees resulting from the Bank of Hiawassee acquisition.  The Company consolidated the data processing and back office functions of the Bank of Hiawassee into the existing Citizens South Bank systems during the third quarter of 2010 which resulted in a reduction of employees.  Occupancy and equipment expense also increased due to the acquisition of Bank of Hiawassee which added five branch offices and an operations center.  The Company purchased the existing branch offices and related equipment from the FDIC during the third quarter of 2010.  Data processing increased due to the operation of two separate data processing systems resulting from the acqui sition.  The acquired data processing system was converted into the existing data processing system in the third quarter of 2010.  Amortization of intangible assets was higher due to the amortization expense related to the $1.6 million core deposit intangible that was created as a result of the acquisition.  This intangible asset is being amortized over an eight-year period using the accelerated method.  The increased number of foreclosed properties and the lower real estate values resulted in the increased valuation adjustment on other real estate owned.  For the nine month period ended September 30, 2009, management determined that there were $547,000 of other-than-temporary impairments on investment securities. Management determined that there were no other-than-temporary impairments on investment securities for the nine month period ended September 30, 2010. Acquisition and integration expenses were related to costs associated with the Bank of Hiawassee a cquisition.  The integration of Bank of Hiawassee was completed in the third quarter of 2010.  Other expenses increased primarily as a result of higher collection costs and expenses associated with the Company’s other real estate owned.  These expenses include the payment of delinquent taxes, insurance, and maintenance.

Income taxes.Income taxes amounted to $5.7 million for the nine months ended September 30, 2010, compared to a benefit of $887,000 for the nine months ended September 30, 2009.  This increase was largely due to the $16.7 million increase in income before income taxes.  The Company’s effective tax rate for the first nine months of 2010 was 35.4%, which is higher than its historical effective tax rate due to the fact that a significant portion of the Company’s income generated during the nine-month period was not generated from tax-advantaged sources.  The Company generates nontaxable income from interest earned on bank-qualified municipal securities and loan s and increases in cash value on bank-owned life insurance policies in order to reduce its overall tax burden.

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Liquidity

The objectives of the Company’s liquidity management policy include providing adequate funds to meet the cash needs of both borrowers and depositors, to provide for the on-going operations of the Company, and to capitalize on opportunities for expansion.  Liquidity management addresses the Company’s ability to meet deposit withdrawals on demand or at contractual maturity, to repay borrowings as they mature, and to fund new loans and investments as opportunities arise.  The primary sources of internally generated funds are principal and interest payments on loans receivable, increases in local deposits, cash flows generated from operations, and cash flows generated by investments.  As of September 30, 2010, the Company’s cash and cash equivalents totaled $154.1 million.  Of this amount, $132.5 million was held in the Company’s account with the Federal Reserve Bank.  If the Company requires funds beyond its internal funding capabilities, it may rely upon external sources of funds such as brokered deposits, repurchase agreements, and advances.  The Company has $77.4 million available to draw from its line of credit with the FHLB.  The FHLB functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB, we are required to own capital stock in the FHLB and we are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities that are obligations of, or guaranteed by, U.S. Government Agencies, or Government Sponsored Enterprises) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Dependin g on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit.  The Company also has $16.0 million available from an unsecured federal funds accommodation with Pacific Coast Bankers Bank (“PCBB”).  PCBB is the Company’s primary correspondent bank. The federal funds facility is available through June 30, 2011, and is used for the purpose of providing daily liquidity as needed by the Company.  Outstanding advances made under this facility are generally repaid on a daily basis at a rate determined by PCBB based on their marginal cost of funds.  Advances are limited to not more than 10 consecutive days at a time.  The Company also has an unsecured federal funds accommodation with CenterState Bank of Florida in the amount of $5.0 million.  The credit facility which is used to fund short-term liquidity needs may be termina ted at any time and may not be outstanding for more than 14 consecutive days.   The Company may also solicit brokered deposits for providing funds for asset growth.  As of September 30, 2010, the Company had no outstanding brokered deposits and $8.6 million of internet deposits that were assumed from the acquisition.  These deposits are not renewed at maturity. The Company believes that it has sufficient sources of liquidity to fund the cash needs of both borrowers and depositors, to provide for the ongoing operations of the Company, and to capitalize on opportunities for expansion.

In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements.  Commitments to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  The funding of these commitments and previously approved undisbursed lines of credit could affect the Company's liquidity position.  At September 30, 2010, the Company had loan commitments of $25.0 million, unused lines of credit of $92.0 million, and undisbursed construction loan proceeds of $523,000.  See Note 11 – Commitments to Extend Credit for additional details. The Company also has various leases in place to provide office space for four full-service of fices and one in-store office.  The cost of these leases for 2009 was $467,000.  Management does not expect any material changes in the amount of the leases over the next five years. Short-term borrowings totaled $11.8 million at September 30, 2010.  These short-term borrowings consisted of $9.8 million of daily repurchase agreements and $2.0 million of FHLB advances that mature over the next 12 months. The Company does not have any special purpose entities or other similar forms of off-balance-sheet financing. The Company believes that given its current level of internal and external sources of liquidity, it has adequate resources to fund loan commitments and lines of credit, repay short-term borrowing if necessary, and any fund any other normal obligations that may arise in the near future.

Capital Resources

The Bank is subject to various regulatory capital requirements administered by the banking regulatory agencies. Failure to meet minimum capital requirements can result in certain mandatory and possibly discretionary actions by

31

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

The Bank’s actual capital levels and regulatory capital ratios as of September 30, 2010, are presented in the following table.

						Minimum Requirements
	Actual					to be Well Capitalized
	Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Regulatory Capital Ratios:
Total risk-based capital (to risk-weighted assets)	$	112,887		16.83	%	$	67,073		10.00	%
Tier 1 capital (to risk-weighted assets)		104,469		15.58	%		40,243		6.00	%
Tier 1 capital (to adjusted total assets)		104,469		9.58	%		54,525		5.00	%
Tangible capital (to adjusted total assets)		104,469		9.58	%		32,715		3.00	%

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

As described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2009, asset/liability management involves the evaluation, monitoring and management of interest rate risk, liquidity and funding. While the Board of Directors has overall responsibility for the Company’s asset/liability management policies, the Bank’s Asset and Liability Committee monitors loan, investment, and liability portfolios to ensure comprehensive management of interest rate risk and adherence to the Bank’s policies.

Item 4.  Controls and Procedures

Our management, with the participation of our Principal Executive Officer and our Principal Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures in accordance with Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”).  Based upon their evaluation, our Principal Executive Officer and our Principal Financial Officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective.

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

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Part II.  Other Information

Item 1.       Legal Proceedings

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

Item 1A.    Risk Factors

Except as previously described in Quarterly filings on Form 10-Q and other filings the Company makes with the SEC, there have been no material changes to the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

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

The Company did not repurchase any common stock during the quarter ended September 30, 2010.

Item 6.       Exhibits

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

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

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

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

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SIGNATURES

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

Citizens South Banking Corporation

Date: November 12, 2010                                                                           By: /s/ Kim S. Price

Kim S. Price

President and Chief Executive Officer

Date: November 12, 2010                                                                           By; /s/ Gary F. Hoskins

 Gary F. Hoskins

 Executive Vice President, Chief Financial Officer

 and Treasurer

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