Overview of Financial Condition and Results of Operations

Citizens South Banking Corporation (the "Company") is a Delaware corporation that owns all of the outstanding shares of common stock of Citizens South Bank (the "Bank"), a federally chartered stock savings bank headquartered in Gastonia, North Carolina. The Company's principal business activities are overseeing and directing the business of the Bank. The Company's assets consist primarily of the outstanding capital stock of the Bank, deposits held at the Bank, and investment securities. The Bank's principal business activity is offering FDIC-insured deposit accounts to local customers through its 15 branch offices and investing those deposits, together with funds generated from operations and borrowings, in residential and nonresidential real estate loans, construction loans, commercial business loans, consumer loans, investment securities, and mortgage-backed securities. The Bank also acts as a broker in both the origination of loans secured by one-to-four family residences and in the sale of uninsured financial products (see Item 1. "Business" of this report for additional details).

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

On December 12, 2008, Citizens South Banking Corporation entered into a Letter Agreement (the "Purchase Agreement") with the United States Department of the Treasury ("U.S. Treasury") pursuant to which the Company has issued and sold to Treasury: (i) 20,500 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share (the "Series A Preferred Stock"), having a liquidation amount per share equal to $1,000, for a total price of $20,500,000 and (ii) a warrant ("Warrant") to purchase 428,870 shares of the Company's common stock, par value $0.01 per share (the "Common Stock"), at an exercise price per share of $7.17. The Series A Preferred Stock pays cumulative dividends at a rate of 5% per annum for the first five years and thereafter at a rate of 9% per annum. According the original Purchase Agreement, the Company may not redeem the Series A Preferred Stock during the first three years except with the proceeds from a qualified equity offering. However, subsequent to the execution of the Purchase Agreement, legislation was passed which allowed the repayment of the Series A Preferred Stock to be repaid at any time from non-equity sources. After three years, the Company may, at its option, redeem the Series A Preferred Stock at the liquidation amount plus accrued and unpaid dividends. The Series A Preferred Stock is generally non-voting. Prior to December 12, 2011, and unless the Company has redeemed all of the Series A Preferred Stock or the U.S. Treasury has transferred all of the Series A Preferred Stock to a third party, the approval of the U.S. Treasury will be required for the Company to increase its common stock dividend or repurchase its common stock or other equity or capital securities, other than in certain circumstances specified in the Purchase Agreement. The Warrant has a ten-year term and is immediately exercisable. The Warrant provides for the adjustment of the exercise price and the number of shares of the Company's common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of the Company's common stock, and upon certain issuances of the Company's common stock at or below a specified price relative to the then current market price of the Company's common stock. If, on or prior to December 31, 2009, the Company receives aggregate gross cash proceeds of not less than the purchase price of the Series A Preferred Stock from one or more "qualified equity offerings," the number of shares of common stock issuable pursuant to the Warrant will be reduced by one-half of the original number of shares, taking into account all adjustments. Pursuant to the Purchase Agreement, the U.S. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant. Both the Series A Preferred Stock and Warrant will be accounted for as components of Tier 1 capital. The Series A Preferred Stock and the Warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. The Company has agreed to register for resale the Series A Preferred Stock, the Warrant and the shares of common stock underlying the Warrant (the "Warrant Shares") if and when requested to do so in writing by the U.S. Treasury. Neither the Series A Preferred Stock nor the Warrant will be subject to any contractual restrictions on transfer, except that the U.S. Treasury may only transfer or exercise an aggregate of one-half of the Warrant Shares prior to the earlier of the date on which the Company receives aggregate gross cash proceeds of not less than the purchase price of the Series A Preferred Stock from one or more "qualified equity offerings" and December 31, 2009. The U.S. Treasury also placed certain restrictions on the amount and type of compensation that can be paid to certain senior level executives of the Company.

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

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

Forward-Looking Statements

This report contains certain forward-looking statements that represent the Company's expectations or beliefs concerning future events. Such forward-looking statements are based on our current beliefs and expectations and are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are beyond our control. These forward-looking statements are based on assumptions with respect to future business strategies and decisions that are subject to change based on changes in the economic and competitive environment in which we operate. Forward-looking statements speak only as of the date they are made and the Company is under no duty to update these forward-looking statements or to reflect the occurrence of unanticipated events. A number of factors could cause actual conditions, events, or results to differ significantly from those described in the forward-looking statements. Factors that could cause such a difference include, but are not limited to, the timing and amount of revenues that may be recognized by the Company, changes in local or national economic trends, increased competition among depository and financial institutions, continuation of current revenue and expense trends (including trends affecting chargeoffs and provisions for loan losses), changes in interest rates, changes in the shape of the yield curve, and adverse legal, regulatory or accounting changes. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on these statements. Readers should carefully review the risk factors described in other documents the Company files from time to time with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and Current Reports on Form 8-K.

Critical Accounting Policies

The accounting and financial policies of the Company and its subsidiaries are prepared in accordance with accounting principles generally accepted in the United States and conform to general practices in the banking industry. We consider accounting policies that require significant judgment and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. Changes in underlying factors, assumptions or estimates could have a material impact on our future financial condition and results of operations. Based on the size of the item or significance of the estimate, the following accounting policies are considered critical to our financial results.

Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance sufficient to absorb estimated probable loan losses inherent in the Bank's portfolio at the measurement date. Management's determination of the adequacy of the allowance is based on quarterly evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the loss for each type of loan and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of the collateral. Management has established a systematic method for periodically evaluating the credit quality of the loan portfolio in order to establish an allowance for loan losses. The methodology is set forth in a formal policy and includes a review of all loans in the portfolio on which full collectability may or may not be reasonably assured. The loan review considers among other matters, the estimated fair value of the collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonable estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Specific allowances are established for certain individual loans that management considers impaired under Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan." The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower, the term of the loan, general economic conditions, and in the case of a secured loan, the quality of the collateral. We increase our allowance for loan losses by charging provisions for loan losses against our current period income. Management's periodic evaluation of the adequacy of the allowance is consistently applied and is based on our past loan loss experience, particular risks inherent in the different kinds of lending that we engage in, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, current economic conditions, and other relevant internal and external factors that affect loan collectability. Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

Other-Than-Temporary Impairment of Securities. On at least a quarterly basis management reviews all investment securities with significant declines in fair value for potential other-than-temporary impairment pursuant to the guidance provided by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. In November 2007, the Financial Accounting Standards Board ("FASB") issued Staff Position ("FSP") FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The FSP addressed the determination as to when an investment is considered impaired, whether the impairment is other-than-temporary, and the measurement of an impairment loss. It also included accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amended SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and APB Opinion 18, The Equity Method of Accounting for Investments in Common Stock.

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

Level 1:       Quoted prices in active markets for identical assets or
liabilities.
Level 2:       Observable inputs other than the quoted prices included in Level
1.
Level 3:       Unobservable inputs.

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

Effective December 31, 2008, management evaluated the Company's investment portfolio and determined that all unrealized losses were the direct result of temporary changes in interest rates and that such losses may be recovered in the foreseeable future. The Company has the ability to hold these investments to maturity if necessary in order to recover any temporary losses that may presently exist. As a result, management did not consider any unrealized losses as "other-than-temporary" as of December 31, 2008.

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

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

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

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

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

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

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

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

Total stockholders' equity increased by $20.7 million, or 24.6%, from $84.0 million at December 31, 2007 to $104.7 million at December 31, 2008. This increase was primarily due to the sale of $20.5 million in Series A Preferred stock, net income of $3.1 million and a $368,000 decrease in accumulated losses on investments available for sale. These increases in stockholders' equity were partly offset by the repurchase of 102,828 shares of common stock for $1.0 million at an average price of $9.91 per share. These shares were repurchased as a part of stock repurchase plans announced in November 2007 and June 2008. The November 2007 repurchase plan provided for the repurchase of 200,000 shares, or approximately 2.5% of the then outstanding shares. All of the shares authorized . . .