VSB Bancorp 10-Q 2008 Q3 Quarterly report

UNITED STATES
SECURITY AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20849

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	FOR THE QUARTER ENDEDSeptember 30, 2008
o	TRANSITION REPORT PURSUANT TO SECTION 13 OF THE EXCHANGE ACT FOR THE TRANSITION PERIOD

COMMISSION FILE NUMBER 0-50237

VSB Bancorp, Inc.

(Exact name of registrant as specified in its charter)

New York

(State or other jurisdiction of incorporation or organization)

11 - 3680128

(I. R. S. Employer Identification No.)

4142 Hylan Boulevard, Staten Island, New York 10308

(Address of principal executive offices)

(718) 979-1100

Registrant’s telephone number

Common Stock

(Title of Class)

Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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.

Yesx Noo

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

Large Accelerated Filer  o	Accelerated Filer    o
Non-Accelerated Filer    o	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):

Yeso Nox

Par Value: $0.0001 Class of Common Stock

The Registrant had 1,898,984 common shares outstanding as of November 5, 2008.

CROSS REFERENCE INDEX

		Page
	PART I
Item 1	Consolidated Statements of Financial Condition as of September 30, 2008 and December 31, 2007 (unaudited)	4
	Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2008 and 2007 (unaudited)	5
	Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2008 and the Year Ended December 31, 2007 (unaudited)	6
	Consolidated Statements of Cash Flows for the Three and Nine Months Ended September 30, 2008 and 2007 (unaudited)	7
	Notes to Consolidated Financial Statements for the Three and Nine Months Ended September 30, 2008 and 2007 (unaudited)	8 to 14
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14 to 24
Item 4	Controls and Procedures	24
PART II
Item 1	Legal Proceedings	24
Signature Page		25
	Exhibit 31.1, 31.2, 32.1, 32.2	26 to 29

2

Forward-Looking Statements

          When used in this periodic report, or in any written or oral statement made by us or our officers, directors or employees, the words and phrases “will result,” “expect,” “will continue,” “anticipate,” “estimate,” “project,” or similar terms are intended to identify “forward-looking statements.” A variety of factors could cause our actual results and experiences to differ materially from the anticipated results or other expectations expressed in any forward-looking statements. Some of the risks and uncertainties that may affect our operations, performance, development and results, the interest rate sensitivity of our assets and liabilities, and the adequacy of our loan loss allowance, include, but are not limited to:

· deterioration in local, regional, national or global economic conditions which could result in, among other things, an increase in loan delinquencies, a decrease in property values, or a change in the real estate turnover rate;

· changes in market interest rates or changes in the speed at which market interest rates change;

· changes in laws and regulations affecting the financial service industry;

· changes in competition; and

· changes in consumer preferences by our customers or the customers of our business borrowers.

          Please do not place undue reliance on any forward-looking statement, which speaks only as of the date made. There are many factors, including those described above, that could affect our future business activities or financial performance and could cause our actual future results or circumstances to differ materially from those we anticipate or project. We do not undertake any obligation to update any forward-looking statement after it is made.

3

VSB Bancorp, Inc.
Consolidated Statements of Financial Condition
(unaudited)

	September 30, 2008			December 31, 2007
Assets:
Cash and due from banks	$	15,609,220		$	17,696,879
Investment securities, available for sale		120,743,189			117,814,117
Loans receivable		64,925,020			62,373,078
Allowance for loan loss		(942,550	)		(927,161	)
Loans receivable, net		63,982,470			61,445,917
Bank premises and equipment, net		3,787,631			3,931,679
Accrued interest receivable		765,340			799,249
Deferred taxes		1,296,799			991,297
Other assets		722,401			1,114,431
Total assets	$	206,907,050		$	203,793,569
Liabilities and stockholders’ equity:
Liabilities:
Deposits:
Demand and checking	$	60,884,999		$	62,525,053
NOW		17,961,859			16,931,113
Money market		19,987,754			20,534,721
Savings		13,128,463			11,349,111
Time		70,910,856			64,738,564
Total Deposits		182,873,931			176,078,562
Escrow deposits		399,486			255,881
Subordinated debt		—			5,155,000
Accounts payable and accrued expenses		1,457,802			1,420,321
Total liabilities		184,731,219			182,909,764
Stockholders’ equity:
Common stock, ($.0001 par value, 3,000,000 shares authorized, 1,923,884 issued and outstanding at September 30, 2008 and 1,900,509 issued and outstanding at December 31, 2007)		192			190
Additional paid in capital		9,219,384			9,107,119
Retained earnings		14,213,337			13,226,395
Unearned Employee Stock Ownership Plan shares		(944,019	)		(1,070,827	)
Accumulated other comprehensive loss, net of taxes of $269,271 and $330,668, respectively		(313,063	)		(379,072	)
Total stockholders’ equity		22,175,831			20,883,805
Total liabilities and stockholders’ equity	$	206,907,050		$	203,793,569

See notes to consolidated financial statements.

4

VSB Bancorp, Inc.
Consolidated Statements of Operations
(unaudited)

	Three months ended September 30, 2008			Three months ended September 30, 2007			Nine months ended September 30, 2008			Nine months ended September 30, 2007
Interest and dividend income:
Loans receivable	$	1,276,288		$	1,500,123		$	3,693,696		$	4,573,820
Investment securities		1,474,099			1,320,528			4,289,758			3,914,686
Other interest earning assets		48,314			297,268			225,159			809,094
Total interest income		2,798,701			3,117,919			8,208,613			9,297,600
Interest expense:
NOW		31,612			37,940			96,545			96,689
Money market		64,094			137,741			232,695			321,150
Savings		19,754			24,531			56,927			74,314
Subordinated debt		36,606			89,040			214,685			267,119
Time		365,462			619,975			1,265,289			1,862,985
Total interest expense		517,528			909,227			1,866,141			2,622,257
Net interest income		2,281,173			2,208,692			6,342,472			6,675,343
Provision (credit) for loan loss		40,000			(15,000	)		125,000			(45,000	)
Net interest income after provision for loan loss		2,241,173			2,223,692			6,217,472			6,720,343
Non-interest income:
Loan fees		11,778			15,658			55,286			63,658
Service charges on deposits		544,686			457,023			1,570,203			1,319,422
Net rental income (loss)		13,796			(2,568	)		23,888			(876	)
Other income		33,705			69,524			144,724			233,989
Total non-interest income		603,965			539,637			1,794,101			1,616,193
Non-interest expenses:
Salaries and benefits		866,644			936,903			2,645,315			2,892,221
Occupancy expenses		376,699			352,297			1,092,889			1,032,022
Legal expense		67,939			52,384			187,725			50,750
Professional fees		62,900			56,700			186,400			153,000
Computer expense		63,772			64,604			176,076			201,975
Directors’ fees		54,200			52,600			169,150			160,450
Other expenses		343,576			318,873			1,078,502			974,050
Total non-interest expenses		1,835,730			1,834,361			5,536,057			5,464,468
Income before income taxes		1,009,408			928,968			2,475,516			2,872,068
Provision/(benefit) for income taxes:
Current		777,900			381,296			1,511,490			1,229,835
Deferred		(311,196	)		51,393			(366,898	)		108,162
Total provision for income taxes		466,704			432,689			1,144,592			1,337,997
Net income	$	542,704		$	496,279		$	1,330,924		$	1,534,071
Earnings per share:
Basic	$	0.29		$	0.27		$	0.72		$	0.84
Diluted	$	0.29		$	0.26		$	0.71		$	0.82
Comprehensive income	$	576,720		$	1,261,399		$	1,396,933		$	2,066,807
Book value per common share	$	11.53		$	10.52		$	11.53		$	10.52

See notes to consolidated financial statements.

5

VSB Bancorp, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
Year Ended December 31, 2007 and Nine Months Ended September 30, 2008
(unaudited)

	Number of Common Shares		Common Stock		Additional Paid-In Capital			Retained Earnings			Unearned ESOP Shares			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity
Balance at January 1, 2007		1,891,759	$	189	$	8,667,665		$	11,293,200		$	(1,239,905	)	$	(1,379,878	)	$	17,341,271
Exercise of stock option, including tax benefit		8,750		1		77,832												77,833
Stock-based compensation						162												162
Amortization of earned portion of ESOP common stock												169,078						169,078
Amortization of deficit fair value of cost - ESOP						(37,566	)											(37,566	)
Transfer from ESOP repurchase obligation						399,026												399,026
Cash dividends declared ($0.06 per share)									(114,031	)								(114,031	)
Comprehensive income:
Net income									2,047,226									2,047,226
Other comprehensive income, net:
Change in unrealized loss on securities available for sale, net of tax effects		—		—		—			—			—			1,000,806			1,000,806
Total comprehensive income																		3,048,032
Balance at December 31, 2007		1,900,509		190		9,107,119			13,226,395			(1,070,827	)		(379,072	)		20,883,805
Exercise of stock option, including tax benefit		23,375		2		164,857												164,859
Stock-based compensation						959												959
Amortization of earned portion of ESOP common stock												126,808						126,808
Amortization of deficit fair value of cost - ESOP						(53,551	)											(53,551	)
Cash dividends declared ($0.06 per share)									(343,982	)								(343,982	)
Comprehensive income:
Net income									1,330,924									1,330,924
Other comprehensive income, net:
Change in unrealized loss on securities available for sale, net of tax effects		—		—		—			—			—			66,009			66,009
Total comprehensive income																		1,396,933
Balance at September 30, 2008		1,923,884	$	192	$	9,219,384		$	14,213,337		$	(944,019	)	$	(313,063	)	$	22,175,831

6

VSB Bancorp, Inc.
Consolidated Statements of Cash Flows
(unaudited)

	Three months ended Sept. 30, 2008			Three months ended Sept. 30, 2007			Nine months ended Sept. 30, 2008			Nine months ended Sept. 30, 2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	542,704		$	496,279		$	1,330,924		$	1,534,071
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		161,329			160,243			465,925			468,265
Accretion of income, net of amortization of premium		(51,907	)		(58,635	)		(163,219	)		(166,619	)
ESOP compensation expense		23,680			31,123			73,257			102,662
Stock-based compensation expense		320			—			959			—
Provision/(credit) for loan losses		40,000			(15,000	)		125,000			(45,000	)
Decrease/(increase) in prepaid and other assets		353,431			78,465			392,030			(97,176	)
(Increase)/decrease in accrued interest receivable		(33,296	)		(10,013	)		33,909			343
(Increase)/decrease in deferred income taxes		(136,522	)		51,393			(366,898	)		134,543
Increase/(decrease) in accrued expenses and other liabilities		68,249			209,488			37,481			(445,973	)
Net cash provided by operating activities		967,988			943,343			1,929,368			1,485,116
CASH FLOWS FROM INVESTING ACTIVITIES:
Net (increase)/decrease in loan receivable		(1,741,617	)		1,419,437			(2,563,409	)		6,961,389
Proceeds from repayment of investment securities, available for sale		6,021,304			11,598,851			20,423,422			24,358,579
Purchases of investment securities, available for sale		(1,547,630	)		(8,002,116	)		(23,160,013	)		(19,513,770	)
Purchases of premises and equipment		(153,994	)		(36,193	)		(321,878	)		(791,328	)
Net cash provided by/(used in) investing activities		2,578,063			4,979,979			(5,621,878	)		11,014,870
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease)/ increase in deposits		(5,787,118	)		(8,654,645	)		6,938,974			(5,611,356	)
Payment of Subordinated Debt		(5,155,000	)		—			(5,155,000	)		—
Exercise stock option		112,859			—			164,859			—
Cash dividends paid		(115,433	)		—			(343,982	)		—
Net cash (used in)/provided by financing activities		(10,944,692	)		(8,654,645	)		1,604,851			(5,611,356	)
NET(DECREASE)/ INCREASE IN CASH AND CASH EQUIVALENTS		(7,398,641	)		(2,731,323	)		(2,087,659	)		6,888,630
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		23,007,861			34,983,022			17,696,879			25,363,069
CASH AND CASH EQUIVALENTS, END OF PERIOD	$	15,609,220		$	32,251,699		$	15,609,220		$	32,251,699
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest	$	517,965		$	793,429		$	2,154,201		$	2,844,837
Taxes	$	522,933		$	300,000		$	1,250,259		$	1,507,459
Transfer of construction in progress to premises and equipment	$	—		$	—		$	—		$	2,142,866

7

VSB BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINEMONTHS ENDED SEPTEMBER 30, 2008 AND2007

1. GENERAL

          VSB Bancorp, Inc. (“Bancorp” or “Company”) is the holding company for Victory State Bank (“Bank”), a New York State chartered commercial bank. On May 30, 2003 as the result of a reorganization of the Bank into the holding company form of organization, the stockholders of the Bank became the stockholders of VSB Bancorp, Inc. As a result of the reorganization the stockholders of VSB Bancorp, Inc. received three shares of VSB Bancorp, Inc. stock for each two shares of Victory State Bank stock. Each stockholder owned the same percentage interest in VSB Bancorp immediately after the reorganization that the stockholder owned in the Bank immediately before the reorganization, subject to immaterial differences due to adjustments for cash in lieu of fractional shares. VSB Bancorp now owns 100% of the capital stock of the Bank. No stockholders of the Bank exercised dissenter’s rights to receive cash instead of shares of the Company. The transaction between these entities under common control was accounted for at historical cost on an “as if pooled basis”. Our common stock now trades on the NASDAQ Global Market (“NASDAQ GM”) effective August 4, 2008, under the stock symbol “VSBN”.

          Through the Bank, the Company is primarily engaged in the business of commercial banking, and to a lesser extent retail banking. The Bank gathers deposits from individuals and businesses primarily in Staten Island, New York and makes loans throughout that community. The Bank invests funds that are not used for lending primarily in government securities, mortgage backed securities and collateralized mortgage obligations. Customer deposits are insured, up to the applicable limit, by the Federal Deposit Insurance Corporation (“FDIC”). The Bank is supervised by the New York State Banking Department and the FDIC.

          The accompanying unaudited interim consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X and, therefore, do not include all the disclosures necessary for a complete presentation of the financial statements in conformity with U.S. generally accepted accounting principles. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results of operations for the interim period. The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the entire year or any other interim period.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

          The following is a description of the significant accounting and reporting policies followed in preparing and presenting the accompanying consolidated financial statements. These policies conform with accounting principles generally accepted in the United States of America (“GAAP”).

          Principles of Consolidation - The consolidated financial statements of the Company include the accounts of the Company, including its subsidiary Victory State Bank. All significant inter-company accounts and transactions between the Company and Bank have been eliminated in consolidation.

          Use of Estimates - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. Actual results can differ from those estimates. The allowance for loan losses, prepayment estimates on the mortgage-backed securities and Collateralized Mortgage Obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change.

8

          Reclassifications –Some items in the prior year financial statements were reclassified to conform to the current presentation.

          Cash and Cash Equivalents – Cash and cash equivalents consists of cash on hand, due from banks and interest-bearing deposits. Net cash flows are reported for customer loan and deposit transactions and interest-bearing deposits. Regulation D of the Board of Governors of the Federal Reserve System requires that Victory State Bank maintain non-interest-bearing deposits or cash on hand as reserves against its demand deposits. The amount of reserves which Victory State Bank is required to maintain depends upon its level of transaction accounts. During the fourteen day period from September 25, 2008 through October 8, 2008, Victory State Bank was required to maintain reserves, after deducting vault cash, of $3,464,000. Reserves are required to be maintained on a fourteen day basis, so, from time to time, Victory State Bank may use available cash reserves on a day to day basis, so long as the fourteen day average reserves satisfy Regulation D requirements. Victory State Bank is required to report transaction account levels to the Federal Reserve on a weekly basis.

          Interest-bearing bank balances – Interest-bearing bank balances mature overnight and are carried at cost.

          Investment Securities, Available for Sale - Investment securities, available for sale, are to be held for an unspecified period of time and include securities that management intends to use as part of its asset/liability strategy. These securities may be sold in response to changes in interest rates, prepayments or other factors and are carried at estimated fair value. Gains or losses on the sale of such securities are determined by the specific identification method. Interest income includes amortization of purchase premium and accretion of purchase discount. Premiums and discounts are recognized in interest income using a method that approximates the level yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are estimated. Unrealized holding gains or losses, net of deferred income taxes, are excluded from earnings and reported as other comprehensive income in a separate component of stockholders’ equity until realized. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

          The Company invests primarily in agency Collateralized Mortgage-Backed Obligations (“CMOs”) with estimated average lives primarily under 4.5 years and Mortgage-Backed Securities. These securities are primarily issued by the Federal National Mortgage Association (“FNMA”), the Government National Mortgage Association (“GNMA”) or the Federal Home Loan Mortgage Corporation (“FHLMC”) and are primarily comprised of mortgage pools guaranteed by FNMA, GNMA or FHLMC. The Company also invests in whole loan CMOs, all of which are AAA rated. These securities expose the Company to risks such as interest rate, prepayment and credit risk and thus pay a higher rate of return than comparable treasury issues.

          Loans Receivable - Loans receivable, that management has the intent and ability to hold for the foreseeable future or until maturity or payoff, are stated at unpaid principal balances, adjusted for deferred net origination and commitment fees and the allowance for loan losses. Interest income on loans is credited as earned.

          It is the policy of the Company to provide a valuation allowance for probable incurred losses on loans based on the Company’s past loan loss experience, known and inherent risks in the portfolio, adverse situations which may affect the borrower’s ability to repay, estimated value of underlying collateral and current economic conditions in the Company’s lending area. The allowance is increased by provisions for loan losses charged to earnings and is reduced by charge-offs, net of recoveries. While management uses available information to estimate losses on loans, future additions to the allowance may be necessary based upon the expected growth of the loan portfolio and any changes in economic conditions beyond management’s control. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management. Management believes, based upon all relevant and available information, that the allowance for loan losses is appropriate.

9

          The Company has a policy that all loans 90 days past due are placed on non-accrual status. It is the Company’s policy to cease the accrual of interest on loans to borrowers past due less than 90 days where a probable loss is estimated and to reverse out of income all interest that is due. The Company applies payments received on non-accrual loans to the outstanding principal balance due before applying any amount to interest, until the loan is restored to an accruing status. On a limited basis, the Company may apply a payment to interest on a non-accrual loan if there is no impairment or no estimated loss on this asset. The Company continues to accrue interest on construction loans that are 90 days past contractual maturity date if the loan is expected to be paid in full in the next 60 days and all interest is paid up to date.

          Loan origination fees and certain direct loan origination costs are deferred and the net amount recognized over the contractual loan terms using the level-yield method, adjusted for periodic prepayments in certain circumstances.

          The Company considers a loan to be impaired when, based on current information, it is probable that the Company will be unable to collect all principal and interest payments due according to the contractual terms of the loan agreement. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impairment is measured on a loan by loan basis for commercial and construction loans. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral. The fair value of the collateral, as reduced by costs to sell, is utilized if a loan is collateral dependent. Large groups of smaller balance homogeneous loans, such as consumer loans and residential loans, are collectively evaluated for impairment.

          Long-Lived Assets - The Company periodically evaluates the recoverability of long-lived assets, such as premises and equipment, to ensure the carrying value has not been impaired. In performing the review for recoverability, the Company would estimate the future cash flows expected to result from the use of the asset. If the sum of the expected future cash flows is less than the carrying amount an impairment will be recognized. The Company reports these assets at the lower of the carrying value or fair value.

          Subordinated Debt - In August of 2003, the Company formed VSB Capital Trust I (the “Trust”). The Trust is a statutory business trust organized under Delaware law and the Company owns all of its common securities. The Trust issued $5.0 million of Trust Preferred Capital Securities to an independent investor and $155,000 of common securities to the Company. The Company issued a $5.16 million subordinated debenture to the Trust. The subordinated debenture was the sole asset of the Trust. On August 8, 2008, the Company repaid the subordinated debenture in full at par, received payment of $155,000 on account of its common securities of the Trust, and all the outstanding Trust Preferred Capital Securities were likewise redeemed, thereby ending the entire arrangement. The Trust is not consolidated with the Company.

          Premises and Equipment - Premises, leasehold improvements, and furniture and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are accumulated by the straight-line method over the estimated useful lives of the respective assets, which range from three to fifteen years. Leasehold improvements are amortized at the lesser of their useful life or the term of the lease.

          Federal Home Loan Bank (FHLB) Stock - The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment. Because this stock is viewed as a long term investment, impairment is based on ultimate recovery of par value, which is the price the Bank pays for the FHLB Stock. Both cash and stock dividends are reported as income.

          Income Taxes - The Company utilizes the liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined on differences between financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws expected to be in effect when the differences are expected to reverse. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

10

          Financial Instruments - In the ordinary course of business, the Company has entered into off-balance sheet financial instruments, primarily consisting of commitments to extend credit.

          Basic and Diluted Net Income Per Common Share - Basic net income per share of common stock is based on 1,871,845 shares and 1,831,436 shares, the weighted average number of common shares outstanding for the three months ended September 30, 2008 and 2007, respectively. Diluted net income per share of common stock is based on 1,898,437 and 1,876,451, the weighted average number of common shares and potentially dilutive common shares outstanding for the three months ended September 30, 2008 and 2007, respectively. The weighted average number of potentially dilutive common shares excluded in calculating diluted net income per common share due to the anti-dilutive effect is 54,758 and 56,110 shares for the three months ended September 30, 2008 and 2007, respectively. Common stock equivalents were calculated using the treasury stock method.

          Basic net income per share of common stock is based on 1,855,523 shares and 1,828,997 shares, the weighted average number of common shares outstanding for the nine months ended September 30, 2008 and 2007, respectively. Diluted net income per share of common stock is based on 1,882,966 and 1,877,025, the weighted average number of common shares and potentially dilutive common shares outstanding for the nine months ended September 30, 2008 and 2007, respectively. The weighted average number of potentially dilutive common shares excluded in calculating diluted net income per common share due to the anti-dilutive effect is 50,207 and 53,097 shares for the nine months ended September 30, 2008 and 2007, respectively. Common stock equivalents were calculated using the treasury stock method.

          The reconciliation of the numerators and the denominators of the basic and diluted per share computations for the three and nine months ended September 30, are as follows:

Reconciliation of EPS	Three months ended September 30, 2008						Three months ended September 30, 2007
	Net Income		Weighted Average Shares		Per Share Amount		Net Income		Weighted Average Shares		Per Share Amount
Basic earnings per common share
Net income available to common stockholders	$	542,704		1,871,845	$	0.29	$	496,279		1,831,436	$	0.27
Effect of dilutive shares
Weighted average shares, if converted				26,592						45,015
Diluted earnings per common share
Net income available to common stockholders	$	542,704		1,898,437	$	0.29	$	496,279		1,876,451	$	0.26

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Reconciliation of EPS	Nine months ended September 30, 2008						Nine months ended September 30, 2007
	Net Income		Weighted Average Shares		Per Share Amount		Net Income		Weighted Average Shares		Per Share Amount
Basic earnings per common share
Net income available to common stockholders	$	1,330,924		1,855,523	$	0.72	$	1,534,071		1,828,997	$	0.84
Effect of dilutive shares
Weighted average shares, if converted				27,443						48,028
Diluted earnings per common share
Net income available to common stockholders	$	1,330,924		1,882,966	$	0.71	$	1,534,071		1,877,025	$	0.82

          Stock Based Compensation - FAS 123, Revised, requires companies to record compensation expense for stock options provided to employees in return for employment service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. This applies to awards granted or modified in fiscal years beginning in 2006.

          Employee Stock Ownership Plan (“ESOP”) - The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Cash dividends on allocated ESOP shares reduce retained earnings; cash dividends on unearned ESOP shares reduce debt and accrued interest. As of August 4, 2008, the Company listed its common stock on the NASDAQ Global Market. We are no longer required to reclassify out of stockholders’ equity an amount equal to the put option of the allocated ESOP shares and we re-classed the 2006 put option allocation in the first quarter of 2007.

          Stock Repurchase Program –On September 8, 2008, the Company announced that its Board of Directors had authorized a Rule 10b5-1 stock repurchase program for the repurchase of up to 100,000 shares of the Company’s common stock. Stock repurchases under the program will be accounted for using the cost method, in which the Company will reflect the entire cost of repurchased shares as a separate reduction of stockholders’ equity on its balance sheet.

          Comprehensive Income- Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses, net of taxes, on securities available for sale which are also recognized as separate components of equity.

          Fair Value Option and Fair Value Measurement- In September 2006, the FASB issued Statement No. 157,Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The standard is effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued Staff Position (FSP) 157-2,Effective Date of FASB Statement No. 157. This FSP delays the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The impact of adoption was not material.

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Statement 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing and asset or liability.

The fair value of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used to in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:

	Fair Value Measurements at September 30, 2008 Using
	September 30, 2008		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Available for sale securities	$	120,743,189	$	—	$	120,743,189	$	—

Impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 3 inputs based on internally customized discounting criteria. As of September 30, 2008, we did not have any impaired loans that were collateral dependent.

          Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis, that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Financial assets and financial liabilities measured at fair value on a non-recurring basis were not significant at September 30, 2008.

          Recently-Issued Accounting Standards -SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115.” SFAS 159 permits entities to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for the Company on January 1, 2008. The Company chose not to exercise the fair value option permitted it under SFAS 159.

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          On November 5, 2007, the SEC issued Staff Accounting Bulletin No. 109,Written Loan Commitments Recorded at Fair Value through Earnings(“SAB 109”). Previously, SAB 105,Application ofAccountingPrinciples to Loan Commitments, stated that in measuring the fair value of a derivative loan commitment, a company should not incorporate the expected net future cash flows related to the associated servicing of the loan. SAB 109 supersedes SAB 105 and indicates that the expected net future cash flows related to the associated servicing of the loan should be included in measuring fair value for all written loan commitments that are accounted for at fair value through earnings. SAB 105 also indicated that internally-developed intangible assets should not be recorded as part of the fair value of a derivative loan commitment, and SAB 109 retains that view. SAB 109 is effective for derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. The adoption of this standard was not material.

Item 2

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Financial Condition at September 30, 2008

Total assets were $206,907,050 at September 30, 2008, an increase of $3,113,481 or, 1.5%, from December 31, 2007. The increase resulted from the investment of funds available to us as the result of an increase in deposits. The deposit increase was caused generally by our efforts to grow our franchise and specifically by the deposit increases at our branch offices. We invested these funds primarily in investment securities available for sale. The net increase in assets can be summarized as follows:

· A $2,929,072 net increase in investment securities available for sale and

· A $2,536,553 net increase in net loans receivable, partially offset by

· A $2,087,659 net decrease in cash and cash equivalents.

          In addition, we also experienced changes in other asset categories due to normal fluctuations in operations.

          Our deposits (including escrow deposits) were $183,273,417 at September 30, 2008, an increase of $6,938,974 or 3.9%, from December 31, 2007. The increase in deposits resulted from increases of $6,172,292 in time deposits, $1,779,352 in savings accounts and $1,030,746 in NOW accounts, partially offset by a decrease of $1,496,449 in non-interest demand deposits and $546,967 in money market accounts.

          Total stockholders’ equity was $22,175,831 at September 30, 2008, an increase of $1,292,026 from December 31, 2007. The increase reflected (i) net income of $1,330,924 for the nine months ended September 30, 2008, (ii) an increase of additional paid in capital of $164,857 due to the exercise by management and directors of 23,375 options, (iii) a reduction in the net unrealized loss on securities available for sale of $66,009 and (iv) a reduction of $126,808 in Unearned ESOP shares reflecting the gradual payment of the loan we made to fund the ESOP’s purchase of our stock. These increases were partially offset by $343,982 of dividends paid, representing the three $0.06 per share quarterly cash dividends in 2008.

          The unrealized loss on securities available for sale is excluded from the calculation of regulatory capital. Management does not anticipate selling securities in this portfolio, but changes in market interest rates or in the demand for funds may change management’s plans with respect to the securities portfolio. If there is a material increase in interest rates, the market value of the available for sale portfolio may decline. Management believes that the principal and interest payments on this portfolio, combined with the existing liquidity, will be sufficient to fund loan growth and potential deposit outflow.

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          For financial statement reporting purposes, we record the compensation expense related to the ESOP when shares are committed to be released from the security interest for the loan. The amount of the compensation expense is based upon the fair market value of the shares at that time, not the original purchase price. The initial sale of shares to the ESOP did not increase our capital by the amount of the purchase price because the purchase price was paid by the loan we made to the ESOP. Instead, capital increases as the shares are allocated or committed to be allocated to employee accounts (i.e., as the ESOP loan is gradually repaid), based upon the fair market value of the shares at that time. When we calculate earnings per share, only shares allocated or committed to be allocated to employee accounts are considered to be outstanding. However, all shares that the ESOP owns are legally outstanding, so they have voting rights and, if we pay dividends, dividends will be paid on all ESOP shares.

Effect of Adverse Conditions in the Residential Mortgage Market.

          We do not expect that adverse conditions in the residential mortgage market throughout the United States will have a direct adverse effect on our financial condition or results of operations. We are not a residential mortgage lender. We do not hold any loans in our portfolio of the type that are commonly known as subprime residential mortgage loans. At September 30, 2008, we owned $120.7 million of securities that are either collateralized by residential mortgage loans or that represent shares in pools of such loans. However, 94.8% of those securities are issued or guaranteed by FNMA (Fannie Mae), GNMA (Ginnie Mae) or FHLMC (Freddie Mac). The remainder of the securities portfolio is all investment grade fixed-rate securities rated AAA that are at least five years old. None of those securities have experienced ratings downgrades. Those securities issued or guaranteed by Fannie Mae or Freddie Mac are entirely securities in which we have a relatively senior position in the cash flow received on the underlying mortgages and there is at least one significant class in each security with a lower cash flow priority. As a result, we anticipate that even if here are defaults on the underlying mortgages and even if Fannie Mae or Freddie Mac suffers from economic difficulties, the ultimate recovery of the entire amount owed of the securities we have purchased is reasonably certain.

          Many of our customers, both loan and deposit customers, are involved in the residential construction business in Staten Island. We believe that the turmoil in the national housing and residential mortgage markets has had an adverse effect on some of our customers. An apparent slow down in the local housing market and a noticeable reduction in the availability of residential mortgage loans seems to have had an adverse effect on our customers and reduced their business activity. We believe that this, in turn, has caused a reduction in their demand for loans from us, such as construction loans to build new homes. It also appears to have adversely affected the level of deposits they maintain.

The Effect of Declining Market Interest Rates.

          Market interest rates, especially short term market interest rates, declined substantially from September 2007 to April 2008 as the Federal Reserve reduced the target federal funds rate, which resulted in an immediate and equal reduction in the prime lending rate. The prime rate and the target overnight federal funds rate both declined by 325 basis points during that period, with the most dramatic decline being a 200 basis point decline in the two months from January 22, 2008 through March 18, 2008. As a result, our loan yields (usually based on the prime rate) and our overnight investment yields (based upon the target federal funds rate) declined as market interest rates declined.

          The decline in loan yields and earnings on overnight investments was more rapid than the decline in our cost of funds for a number of reasons. Approximately one-third of our deposits are interest-free checking accounts and the rates on those accounts (already at zero) do not decline as market rates decline. The rates we pay on interest-bearing deposits, because of their lower starting point, cannot be reduced by as much as the basis point decline in market rates because of the need to maintain customer relationships, competitive pressures and the simple fact that if we price our time deposit rate at, hypothetically, 50% of the prime rate, then if the prime rate declines 100 basis points, then deposit rate only declines 50 basis points. In addition, customers have the ability to exercise discretion in moving funds between different types of deposits to maximize their interest earnings.

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          One tool we use to manage market interest rate declines is the imposition of interest rate floors on our prime-based loans. For most of our loans, once the prime rate falls below 6% (which occurred on March 18, 2008), the interest rate remains at 7% per annum regardless of further declines in interest rates. The interest rate floors are one reason for the increase in our spread that we have recently experienced, with spread being 3.13% for the first quarter of 2008, increasing to 3.50% in the second quarter and 3.84% in the third quarter.

          We have some flexibility in allocating our investment choices between the three categories of earning assets – loans, investment securities and other investments (principally overnight investments). As interest rates declined, we elected to invest more of our available liquid assets into investment securities instead of overnight investments. This shift in the mix of our investments allowed us to reduce the effect of declining interest rates because investment securities tend to have higher yields that overnight investments. We were also able to reinvest the payments we received on existing investment securities in securities with rates comparable to the rates we were earning on the securities being repaid because many of the securities being repaid were purchased a number of years ago before market interest rates reached their recent peak towards the end of 2006.

FDIC Temporary Liquidity Program and Capital Purchase Program

          The FDIC has recently instituted the Temporary Liquidity Program in which the FDIC will guarantee, with certain limitations, all senior unsecured debt of eligible financial institutions. The FDIC has also recently increased insurance coverage on non-interest bearing demand accounts to an unlimited amount, but with the payment of an additional assessment fee. The United States Department of the Treasury recently announced a Capital Purchase Program (“CPP”) in which the Treasury will purchase preferred stock from approved institutions, with certain limitations and restrictions. These three programs are all entirely voluntary. VSB Bancorp, Inc. and Victory State Bank, have strong capital (Tier 1 Capital ratio in excess of 10% and Total Risk Based Capital ratio in excess of 25%). We have reported positive and increased quarterly earnings in 2008 and we did not originate or invest in subprime mortgages nor in FNMA and FHLMC preferred stock. Although all of the details of the Treasury and FDIC programs have not yet been announced, we do not currently anticipate that we will participate in any of these programs.

Results of Operations for the Three Months Ended September 30, 2008 and September 30, 2007

          Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities.

          General. We had net income of $542,704 for the quarter ended September 30, 2008, compared to net income of $496,279 for the comparable quarter in 2007. The principal categories which make up the 2008 net income are:

· Interest income of $2,798,701

· Reduced by interest expense of $517,528

· Reduced by a provision for loan losses of $40,000

· Increased by non-interest income of $603,965

· Reduced by non-interest expense of $1,835,730

· Reduced by $466,704 in income tax expense

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          We discuss each of these categories individually and the reasons for the differences between the quarters ended September 30, 2008 and 2007 in the following paragraphs. In general, the principal reason for the increase in net income when comparing the third quarter of 2008 with the same quarter in 2007 was an improvement in our interest rate spread and margin and an increase in non-interest income due to the increase in service charges on deposit accounts (primarily insufficient fund fees) in March of 2008. We were able to maintain the yield on our investment security portfolio as we purchase new securities, with the same risk parameters that we have purchased in the past, at yields comparable to the overall portfolio yield.

          Interest Income.Interest income was $2,798,701 for the quarter ended September 30, 2008, compared to $3,117,919 for the quarter ended September 30, 2007, a decrease of $319,218, or 10.2%. The principal reason for this decrease was a 224 basis point decrease in the yield on our loan portfolio due to lower market interest rates. The effect of the decline in yields was partially mitigated by a $4,704,165 increase in the average balance of loans, our highest yielding asset category. We also used liquid assets, such as overnight investments, to purchase investment securities as we reduced the average balance of overnight investments by $13,519,866 and reallocated the funds to increase the average balance of higher yielding investment securities.

          The 3 basis point increase in the average yield on our investment securities portfolio, from 4.72% to 4.75%, was due to the purchase of new investment securities at higher market rates than the yields on the principal paydowns we received. The yield on investment securities did not decrease as the other interest-earning assets because most of the bonds and notes in our investment portfolio have either fixed interest rates or interest rates that react more slowly to changes in market interest rate conditions. The average balance of our investment portfolio increased by $12,360,237, or 11.13%, between the periods. The increase in volume and the increase in yield resulted in an overall $153,571 increase in interest income from investment securities. The investment securities portfolio represented 92.0% of average non-loan interest earning assets in the 2008 period compared to 82.1% in the 2007 period.

          Interest Expense. Interest expense was $517,528 for the quarter ended September 30, 2008, compared to $909,227 for the quarter ended September 30, 2007, a decrease of 43.1%. The decrease was primarily the result of the repayment of the subordinated debt in August 2008 coupled with a decrease in the rates we paid on deposits, specifically time deposits (166 basis point decrease) and money market accounts (93 basis point decrease). Our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 1.68% from 2.84% between the periods due to the decline in market interest rates.

          Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $2,281,173 for the quarter ended September 30, 2008, an increase of $72,481, or 3.3% over the $2,208,692 in the comparable 2007 quarter. Our net interest spread increased to 3.84% in the third quarter of 2008 from 3.46% in the third quarter of 2007. We were able to main the spread due to the reallocation of overnight investments into investment securities and our net interest margin increased to 4.48% in the third quarter of 2008 from 4.45% in the third quarter of 2007.

          Provision for Loan Losses.We took a provision for loan losses of $40,000 for the quarter ended September 30, 2008 compared to a credit provision for loan losses of $15,000 for the quarter ended September 30, 2007. The increase in the provision was the result of an increase in loan delinquencies. The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management’s evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.

          Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.45% of total loans at September 30, 2008, but there can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.

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          Non-interest Income.Non-interest income was $603,965 for the three months ended September 30, 2008, compared to $539,637 during the same period last year. The $64,328, or 11.9%, increase in non-interest income was a direct result of an $87,663 increase in service charges on deposits and an increase in net rental income of $16,364, partially offset by a decrease of $35,819 in other income. Service fees on deposit accounts, principally non-sufficient funds fees, increased from 2007 to 2008 due to an increase in the number of non-sufficient fund transactions coupled with our decision to increase per item charges for both insufficient fund and bounced check fees and other deposit fees in March of 2008. The increase in net rental income was due to the occupancy of one of the Bank’s subleased properties. The decrease in other income was a result of the loss of a check cashing customer and the fee income associated with that business.

          Non-interest Expense. Non-interest expense was $1,835,730 for the quarter ended September 30, 2008, compared to $1,834,361 for the quarter ended September 30, 2007. The shifts in the individual categories were:

· $24,402 increase in occupancy expenses due to higher utility bills;

· $15,555 increase in legal expenses primarily due to increased collection costs

· $24,703 increase in other expenses due to an increase in advertising expenses in connection with the Bank’s new advertising campaign

· $70,259 decrease in salaries and benefits expense, due in part to the retirement of the former president and reduced incentive and ESOP compensation expense.

          Income Tax Expense. Income tax expense was $466,704 for the quarter ended September 30, 2008, compared to income tax expense of $432,689 for the quarter ended September 30, 2007. The increase in income tax expense was due to the $80,440 increase in income before income taxes in the 2008 quarter. Our effective tax rate for the quarter ended September 30, 2008 was 46.2% and for the quarter ended September 30, 2007 was 46.6%.

Results of Operations for the Nine Months Ended September 30, 2008 and September 30, 2007

          Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities.

          General. We had net income of $1,330,924 for the nine months ended September 30, 2008, compared to net income of $1,534,071 for the comparable period in 2007. The principal categories which make up the 2008 net income are:

· Interest income of $8,208,613

· Reduced by interest expense of $1,866,141

· Reduced by a provision for loan losses of $125,000

· Increased by non-interest income of $1,794,101

· Reduced by non-interest expense of $5,536,057

· Reduced by $1,144,592 in income tax expense

          We discuss each of these categories individually and the reasons for the differences between the nine months ended September 30, 2008 and 2007 in the following paragraphs. In general, the principal reasons for the decline in net income when comparing the first nine months of 2008 with the same period in 2007 were (i) a reduction in the yield on interest-earning assets, primarily in the loan portfolio and other-interest earning assets, which reduced interest income, and (ii) an increase in the provision for loan loss. These were partially offset by the decrease in interest expense due to the drop in the cost of deposits.

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          Interest Income.Interest income was $8,208,613 for the nine months ended September 30, 2008, compared to $9,297,600 for the nine months ended September 30, 2007, a decrease of $1,088,987, or 11.7%. The principal reasons for this decrease were a 221 basis point decrease in the yield on our loan portfolio and a 265 basis point decrease in the yield of other-interest earning assets (principally overnight investments). The decrease was partially offset by the higher average balance of the investment security portfolio with a higher yield, as we reduced other interest earning assets and reallocated the funds to increase the average balance of investment securities. As a result, the average balance of overnight investments decreased by $8,798,003.

          The average yield on our investment securities portfolio increased 4 basis points, from 4.71% to 4.75%, due to the purchase of new investment securities at slightly higher market rates than the yields on the principal paydowns we received. The yield on investment securities did not decrease as did the yields on other interest earning assets because most of the bonds and notes in our investment portfolio have either fixed interest rates or interest rates that react more slowly to changes in market interest rate conditions. The average balance of our investment portfolio increased by $9,574,688, or 8.62%, between the periods. The increase in volume and the increase in yield resulted in an overall $375,072 increase in interest income from investment securities. The investment securities portfolio represented 90.3% of average non-loan interest earning assets in the 2008 period compared to 83.6% in the 2007 period.

          Interest Expense. Interest expense was $1,866,141 for the nine months ended September 30, 2008, compared to $2,622,257 for the nine months ended September 30, 2007, a decrease of 28.8%. The decrease was primarily the result of the repayment of the subordinated debt in August 2008 coupled with a decrease in the rates we paid on deposits, specifically time deposits (a 126 basis point decrease in cost) and money market accounts (a 55 basis point decrease in cost). Our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 2.03% from 2.82% between the periods due to a decline in market interest rates that began in approximately September 2007.

          Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $6,342,472 for the nine months ended September 30, 2008, a decrease of $332,871, or 5.0% over the $6,675,343 in the comparable 2007 period. The decrease resulted principally from a decrease in the yield on our loan portfolio, which was greater than the decrease in the average cost of our deposits, including demand deposits, partially offset by a decrease in the cost of time deposits and an increase in interest income from our investment security portfolio. Our net interest spread decreased to 3.53% in the first nine months of 2008 from 3.58% in the same period of 2007 and our net interest margin, which includes the effect of interest-free demand deposits and capital as funding sources, decreased to 4.29% in the first nine months of 2008 from 4.59% in the same period of 2007.

          Provision for Loan Losses.We took a provision for loan losses of $125,000 for the nine months ended September 30, 2008 compared to a credit to the provision for loan losses of $45,000 for the nine months ended September 30, 2007. The increase in the provision was the result of an increase in loan delinquencies and charge-offs. The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management’s evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.

          Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.45% of total loans at September 30, 2008, but there can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.

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          Non-interest Income.Non-interest income was $1,794,101 for the nine months ended September 30, 2008, compared to $1,616,193 during the same period last year. The $177,908, or 11.0%, increase in non-interest income was a direct result of a $250,781 increase in service charges on deposits (primarily non-sufficient fund fees) and an increase in net rental income of $24,764, partially offset by a decrease of $89,265 in other income. Service charges on deposits increased due to an increase in the number of non-sufficient fund transactions coupled with our decision to increase per item charges for both insufficient fund and bounced check fees and other deposit fees in March of 2008. The increase in net rental income was due to the occupancy of one of the Bank’s subleased properties that was previously vacant. The decrease in other income was a result of the loss of a check cashing customer that had previously generated substantial fee income.

          Non-interest Expense. Non-interest expense was $5,536,057 for the nine months ended September 30, 2008, compared to $5,464,468 for the nine months ended September 30, 2007. The principal causes of the $71,589 increase were:

· $60,867 increase in occupancy expenses due to higher utility costs and the operation of our new main office in Great Kills, which opened in February 2007;

· $136,975 increase in legal expenses primarily due to new collection matters and because in 2007 we received a reimbursement from our insurance company of legal fees previously expensed.

· $104,452 increase in other expenses due to a $74,013 increase in advertising expenses in connection with the Bank’s new advertising campaign and a $40,110 recovery in 2007 of part of a reserve expensed in 2005 for a legal claim that we settled for less than the reserve in 2007

· $246,906 decrease in salaries and benefits expense, due in part to the retirement of the former president and reduced incentive and ESOP compensation expense.

          Income Tax Expense. Income tax expense was $1,144,592 for the nine months ended September 30, 2008, compared to income tax expense of $1,337,997 for the nine months ended September 30, 2007. The reduction in income tax expense was due to the $396,552 decrease in income before income taxes in the 2008 period. Our effective tax rate for the nine months ended September 30, 2008 was 46.2% and for the quarter ended September 30, 2007 was 46.6%.

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VSB Bancorp, Inc.
Consolidated Average Balance Sheets
(unaudited)

	Three Months Ended Sept. 30, 2008								Three Months Ended Sept. 30, 2007								Nine Months Ended Sept. 30, 2008								Nine Months Ended Sept. 30, 2007
	Average Balance			Interest		Yield/ Cost			Average Balance			Interest		Yield/ Cost			Average Balance			Interest		Yield/ Cost			Average Balance			Interest		Yield/ Cost
Assets:
Interest-earning assets:
Loans receivable	$	64,032,229		$	1,276,288		7.61	%	$	59,328,064		$	1,500,123		9.85	%	$	63,070,716		$	3,693,696		7.77	%	$	60,982,376		$	4,573,820		9.98	%
Investment securities, afs		123,434,653			1,474,099		4.75			111,074,416			1,320,528		4.72			120,617,836			4,289,758		4.75			111,043,148			3,914,686		4.71
Other interest-earning assets		10,683,945			48,314		1.80			24,203,811			297,268		4.87			13,025,631			225,159		2.31			21,823,634			809,094		4.96
Total interest-earning assets		198,150,827			2,798,701		5.52			194,606,291			3,117,919		6.30			196,714,183			8,208,613		5.56			193,849,158			9,297,600		6.40
Non-interest earning assets		12,807,546								13,590,653								12,983,052								14,920,697
Total assets	$	210,958,373							$	208,196,944							$	209,697,235							$	208,769,855
Liabilities and equity:
Interest-bearing liabilities:
Savings accounts	$	12,625,903			19,754		0.62		$	11,684,293			24,531		0.83		$	11,813,603			56,927		0.64		$	12,082,515			74,314		0.82
Time accounts		71,347,390			365,462		2.04			66,513,594			619,975		3.70			68,528,843			1,265,289		2.47			66,788,460			1,862,985		3.73
Money market accounts		19,020,866			64,094		1.34			24,043,528			137,741		2.27			20,600,694			232,695		1.51			20,828,643			321,150		2.06
Now accounts		17,695,783			31,612		0.71			19,471,134			37,940		0.77			17,984,043			96,545		0.72			19,672,772			96,689		0.66
Subordinated debt		2,129,239			36,606		6.91			5,155,000			89,040		6.91			4,139,051			214,685		6.91			5,155,000			267,119		6.91
Total interest-bearing liabilities		122,819,181			517,528		1.68			126,867,549			909,227		2.84			123,066,234			1,866,141		2.03			124,527,390			2,622,257		2.82
Checking accounts		65,085,696								60,571,625								63,638,445								63,532,608
Total deposits and subordinated debt		187,904,877								187,439,174								186,704,679								188,059,998
Other liabilities		1,254,024								1,617,370								1,192,190								2,012,645
Total liabilities		189,158,901								189,056,544								187,896,869								190,072,643
Equity		21,799,472								19,140,400								21,800,366								18,697,212
Total liabilities and equity	$	210,958,373							$	208,196,944							$	209,697,235							$	208,769,855
Net interest income/net interest rate spread				$	2,281,173		3.84	%				$	2,208,692		3.46	%				$	6,342,472		3.53	%				$	6,675,343		3.58	%
Net interest earning assets/net interest margin	$	75,331,646					4.48	%	$	67,738,742					4.45	%	$	73,647,949					4.29	%	$	69,321,768					4.59	%
Ratio of interest-earning assets to interest-bearing liabilities		1.61	x							1.53	x							1.60	x							1.56	x
Return on Average Assets (1)		0.97	%							0.92	%							0.84	%							0.97	%
Return on Average Equity (1)		9.40	%							9.99	%							8.07	%							10.89	%
Tangible Equity to Total Assets		10.72	%							9.57	%							10.72	%							9.57	%

(1) Ratios have been annualized.

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Liquidity and Capital Resources

          Our primary sources of funds are increases in deposits, proceeds from the repayment of investment securities, and the repayment of loans. We use these funds to purchase new investment securities and to fund new and renewing loans in our loan portfolio. Remaining funds are invested in short-term liquid assets such as overnight federal funds loans and bank deposits.

          During the nine months ended September 30, 2008, we had a net increase in total deposits of $6,938,974 due to increases of $6,172,292 in time deposits, $1,779,352 in savings accounts and $1,030,746 in NOW, partially offset by a decrease of $1,496,449 in non-interest demand deposits and a $546,967 decrease in money market accounts. We also received proceeds from repayment of investment securities of $20,423,422. We used $23,160,013 of available funds to purchase new investment securities, $5,155,000 to repay our subordinated debt and we had a net loan increase of $2,563,409. These changes resulted in an overall decrease in cash and cash equivalents of $2,087,659.

          In contrast, during the nine months ended September 30, 2007, we had a net decrease in total deposits of $5,611,356 due to a $4,621,334 decrease in time deposits, a $4,824,412 decrease in demand and checking accounts and a $1,416,790 decrease in savings accounts partially offset by a $5,226,118 increase in money market accounts and a $25,062 increase in NOW accounts. We received proceeds from repayment of investment securities of $24,358,579 and we had a net loan reduction of $6,961,389. After funding the deposit decline, we used $19,513,770 of available funds to purchase new investment securities. We also used $2,934,194 of cash for capitalized leasehold improvements and equipment for our new main office in Great Kills. These changes resulted in an overall increase in cash and cash equivalents of $6,888,630.

          Victory State Bank satisfied all capital ratio requirements of the Federal Deposit Insurance Corporation at September 30, 2008, with a Tier I Leverage Capital ratio of 10.31%, a ratio of Tier I Capital to Risk-Weighted Assets ratio of 24.01%, and a Total Capital to Risk-Weighted Assets ratio of 25.06%.

          VSB Bancorp, Inc. satisfied all capital ratio requirements of the Federal Reserve at September 30, 2008, with a Tier I Leverage Capital ratio of 10.66%, a ratio of Tier I Capital to Risk-Weighted Assets ratio of 25.10%, and a Total Capital to Risk-Weighted Assets ratio of 26.15%.

          In August 2008, we unwound our trust preferred securities transaction by calling (and repaying) the $5,155,000 subordinated debenture we had on our balance sheet at June 30, 2008. We used available cash to repay the debenture and we expect that the repayment will have no material adverse effect on our liquidity. We elected to repay the debenture and end the trust preferred transaction because we believe that the future cost to us (3 month LIBOR plus 300 basis points per annum, adjusted every three months) would have exceeded the value of the additional capital that the transaction gave us for regulatory capital purposes. Victory State Bank and VSB Bancorp, Inc. were both well-capitalized for regulatory capital purposes after the debenture was repaid.

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          The following table sets forth our contractual obligations and commitments for future lease payments, time deposit maturities and loan commitments.

Contractual Obligations and Commitments at September 30, 2008

Contractual Obligations	Payment due by Period
	Less than One Year		One to three years		Four to five years		After five years		Total Amounts committed
Minimum annual rental payments under non-cancelable operating leases	$	397,978	$	814,209	$	846,750	$	1,894,566	$	3,953,503
Remaining contractual maturities of time deposits		67,870,301		1,022,814		2,017,741		—		70,910,856
Total contractual cash obligations	$	68,268,279	$	1,837,023	$	2,864,491	$	1,894,566	$	74,864,359

Other commitments	Amount of commitment Expiration by Period
	Less than One Year		One to three years		Four to five years		After five years		Total Amounts committed
Loan commitments	$	23,120,233	$	5,023,898	$	7,453	$	—	$	28,151,584

          Our loan commitments shown in the above table represent both commitments to make new loans and obligations to make additional advances on existing loans, such as construction loans in process and lines of credit. Substantially all of these commitments involve loans with fluctuating interest rates, so the outstanding commitments do not expose us to interest rate risk upon fluctuation in market rates.

Non-Performing Loans

          Management closely monitors non-performing loans and other assets with potential problems on a regular basis. We had nine non-performing loans, totaling $2,088,050, at September 30, 2008, compared to six non-performing loans, totaling $960,217, at December 31, 2007. The following is information about the six largest non-performing loans, totaling $1,928,726 in outstanding principal balance. Management believes it has taken appropriate steps with a view towards maximizing recovery and minimizing loss on these loans.

· $859,968 in three loans to a builder secured and cross-collateralized by first mortgage liens on three lots in Staten Island on which single family houses are being built. The loans are past maturity and we have commenced foreclosure actions. The builder has contracts to sell two of the houses and those houses are near completion. The sale of the two houses at the contract price, if consummated, would be sufficient to pay off all three loans.

· $556,321 in a loan to a business that has ceased operations but which loan is secured by a first mortgage on real property in Suffolk County and personally guaranteed by the principals. The property is listed for sale at a price substantially in excess of the loan amount. The loan is past due and we negotiated and extended an interim work out, pending the completion of a sale of the property. The borrower has made a substantial cash deposit sufficient to bring the loan current, and to pay interest through at least September 2008. The borrowers and the guarantors signed the work out documents in October and we then applied the deposit as agreed.

· $512,437 in two loans to related local businesses. Both loans are in default and confessions of judgment have been filed. We have a security interest in the businesses, personal guaranties of the principals and others, and $100,000 of cash collateral. The borrowers had contracts to sell the businesses upon terms that sufficient to repay our loans, but the closings were contingent upon the receipt of approval of the New York State regulator responsible for regulating the businesses. That approval was received just prior to September 30, 2008, but the closing of the sale had not yet occurred. The businesses were sold in early October and our loans were repaid in their entirety.

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Critical Accounting Policies and Judgments

          We are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. The allowance for loan losses, prepayment estimates on the mortgage-backed securities and Collateralized Mortgage Obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change and to management’s estimates. Actual results can differ from those estimates and may have an impact on our financial statements.

Item 4 –Controls and Procedures

          Evaluation of Disclosure Controls and Procedures: As of September 30, 2008, we undertook an evaluation of our disclosure controls and procedures under the supervision and with the participation of Raffaele M. Branca, President, CEO and CFO. Disclosure controls are the systems and procedures we use that are designed to ensure that information we are required to disclose in the reports we file or submit under the Securities Exchange Act of 1934 (such as annual reports on Form 10-K and quarterly periodic reports on Form 10-Q) is recorded, processed, summarized and reported, in a manner which will allow senior management to make timely decisions on the public disclosure of that information. Mr. Branca concluded that our current disclosure controls and procedures are effective in ensuring that such information is (i) collected and communicated to senior management in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Since our last evaluation of our disclosure controls, we have not made any significant changes in, or corrective actions taken regarding, either our internal controls or other factors that could significantly affect those controls.

          We intend to continually review and evaluate the design and effectiveness of our disclosure controls and procedures and to correct any deficiencies that we may discover. Our goal is to ensure that senior management has timely access to all material financial and non-financial information concerning our business so that they can evaluate that information and make determinations as to the nature and timing of disclosure of that information. While we believe the present design of our disclosure controls and procedures is effective to achieve this goal, future events may cause us to modify our disclosure controls and procedures.

Part II

Item 1 – Legal Proceedings

          The Bank is a defendant in an action pending in Supreme Court, Richmond County, commenced by IndyMac Bank, F.S.B. against the Bank, LaMattina & Associates, Inc. (“LAI”) and various individuals and entities alleged to be officers, directors or otherwise to have relationships with LAI. See the Company’s quarterly report for the quarter ended March 31, 2008 for information with respect to this proceeding.

          IndyMac Bank, F.S.B. (“Old IndyMac”), was closed by the Office of Thrift Supervision (“OTS”) and the Federal Deposit Insurance Corporation (“FDIC”) was appointed as its conservator in July 2008. The OTS then created a new bank (“New IndyMac”) and many of the assets of Old IndyMac were transferred to New IndyMac. The Bank has been advised by opposing legal counsel that the claim in the litigation is owned by Old IndyMac, which is being liquidated by the FDIC. The Bank has been advised that the holder of the claim against the Bank intends to continue to pursue its claim against the Bank. The Bank intends to diligently defend the litigation.

          VSB Bancorp, Inc., is not involved in any pending legal proceedings. The Bank, from time to time, is involved in routine collection proceedings in the ordinary course of business on loans in default and other routine proceedings arising it the ordinary course of business. Management believes that such other routine legal proceedings in the aggregate are immaterial to our financial condition or results of operations.

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Signature Page

          In accordance with the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	VSB Bancorp, Inc.
Date: November 12, 2008	/s/ Raffaele M. Branca
	Raffaele M. Branca
	President and Chief Executive Officer

EXHIBIT INDEX

Exhibit Number	Description of Exhibit
31.1	Rule 13A-14(a)/15D-14(a) Certification of Chief Executive Officer
31.2	Rule 13A-14(a)/15D-14(a) Certification of Chief Financial Officer
32.1	Certification by CEO pursuant to 18 U.S.C. 1350.
32.2	Certification by CFO pursuant to 18 U.S.C. 1350.

Item 6 - Exhibits

Exhibit Number	Description of Exhibit
31.1	Rule 13A-14(a)/15D-14(a) Certification of Chief Executive Officer
31.2	Rule 13A-14(a)/15D-14(a) Certification of Chief Financial Officer
32.1	Certification by CEO pursuant to 18 U.S.C. 1350.
32.2	Certification by CFO pursuant to 18 U.S.C. 1350.

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