Forward Looking Statements

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

Executive Summary

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

The following discussion is provided to assist in understanding and evaluating the Company's results of operations and financial condition and is designed to provide a general overview of the Company's performance for the three- and six-month periods ended June 30, 2009 and 2008. Readers seeking a more in-depth analysis should read the detailed discussions below, as well as the condensed consolidated financial statements and related notes. Financial highlights for the comparable periods are presented in the following table.

                                                 Three months        Three months                        Six months          Six months
Financial Highlights: (unaudited)                    ended               ended                              ended               ended
(Dollars in thousands, except per share data)    June 30, 2009       June 30, 2008      % Change        June 30, 2009       June 30, 2008      % Change

Summary Income Statement:
Interest income - taxable equivalent            $         9,819     $        10,619          (7.5 )%   $        19,650     $        21,715          (9.5 )%
Interest expense                                          4,346               5,571         (22.0 )              9,048              11,756         (23.0 )
Net interest income - taxable equivalent                  5,473               5,048           8.4               10,602               9,959           6.5
Less: Taxable-equivalent adjustment                         141                 136           3.6                  286                 260          10.0
Net interest income                                       5,332               4,912           8.6               10,316               9,699           6.4
Provision for loan losses                                (1,950 )              (750 )       160.0               (2,850 )            (1,095 )       160.3
Noninterest income                                        2,016               1,592          26.6                3,265               3,273          (0.3 )
Noninterest expense                                      (5,239 )            (4,702 )        11.4              (10,176 )            (9,585 )         6.2
Income tax (expense) benefit                                155                (190 )      (181.6 )                216                (460 )      (147.0 )
Net income                                                  314                 862         (63.6 )                771               1,832         (57.9 )
Dividends on preferred stock                               (259 )                 -            NM                 (513 )                 -            NM
Net Income available to common stockholders     $            55     $           862         (93.6 )%   $           258     $         1,832         (85.9 )%

Per Common Share Data:
Earnings:
Basic                                           $          0.01     $          0.12         (91.7 )%   $          0.03     $          0.25         (88.0 )%
Diluted                                                    0.01                0.12         (91.7 )               0.03                0.25         (88.0 )

Weighted average shares:
Basic                                                 7,403,359           7,369,964           0.5 %          7,398,079           7,391,338           0.1 %
Diluted                                               7,403,359           7,434,006          (0.3 )          7,398,079           7,443,803          (0.6 )
End of period shares outstanding                      7,526,854           7,524,016           0.4            7,526,854           7,524,016           0.4

Cash dividends paid                             $          0.04     $         0.085         (52.9 )%   $         0.125                0.17         (26.5 )%
Book value                                                11.11               10.26           8.3                11.11               10.96           1.4
Tangible book value                                        7.07                6.88           2.8                 7.07                6.88           2.8

End of Period Balances:
Total assets                                    $       836,283     $       811,825           3.0 %    $       836,283     $       811,825           3.0 %
Loans, net of deferred fees                             629,962             604,855           4.2              629,962             604,855           4.2
Investment securities                                    97,452             117,613         (17.1 )             97,452             117,613         (17.1 )
Interest-earning assets                                 751,733             720,270           4.4              751,733             670,270          12.2
Deposits                                                616,233             584,801           5.4              616,233             584,801           5.4
Stockholders' equity                                    104,158              82,495          26.3              104,158              82,495          26.7

Average Balances:
Total assets                                    $       841,169     $       790,625           6.4 %    $       832,937     $       783,148           6.4 %
Loans, net of deferred fees                             635,645             588,868           7.9              631,184             577,953           9.2
Investment securities                                   107,140             110,903          (3.4 )            108,836             111,766          (2.6 )
Interest-earning assets                                 751,381             695,151           8.1              745,893             687,863           8.4
Deposits                                                616,936             578,469           6.7              605,046             624,136           4.5
Interest-bearing liabilities                            685,109             655,533           4.5              678,699             646,204           5.0
Stockholders' equity                                    104,813              83,965          24.8              104,875              84,205          24.6

Financial Performance Ratios:
Return on average assets                                   0.03 %              0.44 %       (93.2 )%              0.06 %              0.47 %       (87.2 )%
Return on average common equity                            0.26                4.13         (93.7 )               0.62                4.38         (85.8 )
Noninterest income to average assets                       0.96                0.81          18.3                 0.78                0.84          (6.2 )
Noninterest expense to average assets                      2.49                2.38           4.7                 2.44                2.45          (0.2 )
Efficiency ratio                                          71.29               72.29          (1.4 )              75.58               73.89           2.3

NM = Not Meaningful


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                                                 Three months        Three months                         Six months          Six months
Financial Highlights: (unaudited)                    ended               ended                               ended               ended
(Dollars in thousands, except per share data)    June 30, 2009       June 30, 2008       % Change        June 30, 2009       June 30, 2008       % Change

Net Interest Spread / Margin:
Yield on earnings assets                                   5.26 %              6.12 %        (14.1 )%              5.32 %              6.33 %        (16.0 )%
Cost of funds                                              2.54                3.41          (25.5 )               2.72                3.65          (25.5 )
Net interest spread                                        2.72                2.71            0.4                 2.60                2.68           (3.0 )

Net interest margin                                        2.92                2.91            0.3                 2.87                2.90           (1.0 )

Credit Quality Data:
Allowance for loan losses (ALLL):
Beginning of period                             $         8,730     $         6,428           36.8 %    $         8,026     $         6,144           30.6 %
Add: Provision for loan losses                            1,950                 750          160.0                2,850               1,095          160.3
Less: Net charge-offs                                     1,995                 421          373.8                2,191                 482          354.6
Balance end of period                                     8,685               6,757           28.5                8,685               6,757           28.5

Nonperforming loans (NPLs)                      $        10,360     $         3,880          167.0 %    $        10,360     $         3,880          167.0 %
Other real estate owned                                   2,111                 635          232.4                2,111                 635          232.4
Nonperforming assets (NPAs)                              12,471               4,515          176.2               12,471               4,515          176.2

Allowance for loan losses to total loans                   1.38 %              1.12 %         23.4 %               1.38 %              1.12 %         23.4 %
Net charge-offs to average loans                           0.31                0.07          339.0                 0.35                0.08          336.5
NPLs to total loans                                        1.64                0.64          156.4                 1.64                0.64          156.4
NPAs to total assets                                       1.49                0.56          164.1                 1.49                0.56          164.1
NPAs to total loans and OREO                               1.97                0.75          164.6                 1.97                0.75          164.6

Capital Ratios:
Tangible common equity                                     6.61 %              6.88 %         (3.9 )%              6.61 %              6.88 %         (3.9 )%
Bank-only regulatory capital ratios:
Tier 1                                                    10.35                8.46            1.9                10.35                8.46            1.9
Total risk-based                                          14.31               10.84            3.5                14.31               10.84            3.5
Tier 1 risk-based                                         13.27                9.84            3.4                13.27                9.84            3.4
Tangible equity                                           10.35                8.46            1.9                10.35                8.46            1.9

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 reasonably estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Specific allowances are established for certain individual loans that management considers impaired under 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 FASB issued Staff Position ("FSP") FAS No. 115-1 and FAS No. 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," FAS 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."

In April 2009, the FASB issued FSP SFAS115-2 and SFAS 124-2 as outlined in Note
2. The issuance of these FSPs does not amend existing recognition and measurement guidance related to other-than-temporary impairment of equity securities.

During the second quarter of 2009 the FDIC placed Silverton Bank, the Company's correspondent bank, into receivership. As a result, management determined that the Bank's entire $91,000 equity investment in Silverton Bank was other-than-temporarily impaired. In accordance with SFAS No. 157, "Fair Value Measurements," the Company uses valuation techniques that are appropriate and consistently applied. A fair value 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 is this equity investment, the security was valued using Level 3. The fair value was prepared based on the Company's most recent capital position and total common shares outstanding.

Effective June 30, 2009, management evaluated the Company's investment portfolio and determined that all other unrealized losses were the direct result of temporary changes in interest rates and that such losses may be recovered in the foreseeable future. The Company has the ability to hold these investments to maturity if necessary in order to recover any temporary losses that may presently exist. As a result, management did not consider any additional unrealized losses as "other-than-temporary" as of June 30, 2009.

Comparison of Financial Condition

Assets. Total assets of the Company increased by $19.1 million, or 2.3%, from $817.2 million at December 31, 2008, to $836.3 million at June 30, 2009. This increase was primarily due to a $30.5 million increase in interest-earning bank balances and a $3.3 million increase in loans. These increases were partly offset by an $11.7 million decrease in total investment securities, a $644,000 decrease in Federal Home Loan Bank stock and a $490,000 decrease in other real estate owned.

Interest-earning bank balances, which includes the Bank's deposits at the Federal Reserve Bank, increased by $30.5 million from $613,000 at December 31, 2008, to $31.1 million at June 30, 2009. This increase was primarily attributable to deposit growth of $34.7 million during the first six months of 2009. Management expects that the level of interest-bearing bank balances will be substantially reduced in the second half of 2009 as the excess liquidity from this deposit growth is invested in higher yielding loans and investment securities.

During the six-month period ended June 30, 2009, loans receivable increased by $3.3 million, or 0.5%, to $630.0 million. The growth in loans was primarily comprised of a $36.0 million, or 13.5%, increase in commercial real estate loans, a $10.2 million, or 29.7%, increase in commercial business loans, and a $1.7 million, or 1.6%, increase in consumer loans. These loan increases were partly offset by a $2.7 million, or 3.3%, decrease in permanent one-to-four family residential loans, a $34.0 million, or 47.6%, decrease in residential and commercial construction loans and a $10.0 million, or 18.7% reduction in residential acquisition and development loans. The decrease in construction loans was partly due to the conversion of several larger commercial projects from construction status to permanent status during the period, a decrease in local loan demand and a reduced interest by the Company to pursue these types of loans.

While the economy in the Charlotte region has generally outperformed most other large metropolitan areas of the country, the economy in the Charlotte region continued to slow during 2009. As a result, the Company's loan production slowed to $75.7 million during the first six months of 2009 as compared to $158.7 million during the first six months of 2008. A continued slowdown in the local economy would have a negative impact on the Company's ability to increase the current level of loan growth. Management will seek to continue to grow the loan portfolio in a prudent manner with an emphasis on borrowers that have a demonstrated capacity to meet their debt obligations, even if the local economy continues to slow.

During the six-month period ended June 30, 2009, investment securities decreased by $11.7 million, or 10.7%, to $97.5 million. The decrease was primarily due to the sale of $21.6 million of investment securities and the normal maturities and principal amortization of $11.5 million. Also, during the period, the Company purchased $21.6 million of investments securities. Management expects the investment portfolio to increase as a percentage of total assets over the next quarter as the excess liquidity generated from deposit growth in the first quarter of 2009 is invested in higher-yielding assets.

Other real estate owned, which includes all properties acquired by the Company through foreclosure, totaled $2.1 million at June 30, 2009, compared to $2.6 million at December 31, 2008. At June 30, 2009, other real estate owned consisted of 12 one-to-four family residential dwellings and six residential lots. During the first six months of 2009, the Company foreclosed on five residential lots and six residential properties. Also, during the same period, the Company sold six foreclosed residential properties and one foreclosed commercial property for a loss of $308,000 and reduced the book value of two additional properties by $175,000 due to a drop in real estate prices for comparable properties. All foreclosed properties are written down to their estimated fair value (market value less estimated disposition costs) at acquisition and are located in the Bank's primary lending area. Management will continue to aggressively market foreclosed properties for a timely disposition. Premises and equipment decreased by $451,000, or 2.7%, to $16.4 million at June 30, 2009. This decrease was primarily due to normal depreciation. During the first quarter of 2009, the Company opened a loan production office located in a leased facility in Charlotte, North Carolina. This office is expected to transition into a full-service commercial branch catering mostly to commercial customers before the end of 2009. No significant changes to the Company's premises and equipment are anticipated for the remainder of 2009.

Allowance for loan losses and nonperforming assets. The Company has established a systematic methodology for determining the adequacy of the allowance for loan losses. This methodology is set forth in a formal policy and considers all loans in the portfolio. Specific allowances are established for certain individual loans that management considers impaired. The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. Management's periodic evaluation of the allowance is consistently applied and based on inherent losses in the portfolio, past loan loss experience, risks inherent in the different types of loans, the estimated value of any underlying collateral, current economic conditions, the borrower's financial position, and other relevant internal and external factors that may affect loan collectibility. The allowance for loan losses is increased by charging provisions for loan losses against income. As of June 30, 2009, the allowance for loan losses was $8.7 million, or 1.38% of total loans. Management believes that this amount meets the requirement for losses on loans that management considers to be impaired, for known losses, and for losses inherent in the remaining loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations. The following table presents . . .