UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

_____________

FORM 10-Q

_____________

[x] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2012

or

[  ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ______ to _____

Commission File Number 0-23971
________________________________

Citizens South Banking Corporation

(Exact name of registrant as specified in its charter)

________________________________

Delaware	54-2069979
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification Number)
519 South New Hope Road, Gastonia, NC	28054
(Address of principal executive offices)	(Zip code)

(704) 868-5200

(Registrant's telephone number, including area code)

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

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

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

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

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

As of May 15, 2012, there were 11,506,324 shares outstanding of the Registrant’s common stock, $0.01 par value.

Citizens South Banking Corporation

Index

	Page
Part I.  Financial Information
Item 1.   Financial Statements (unaudited)
Consolidated Statements of Financial Condition at March 31, 2012 and December 31, 2011	1
Consolidated Statements of Operations for the Three months Ended March 31, 2012 and 2011	2
Consolidated Statements of Comprehensive Income for the Three months Ended March 31, 2012 and 2011	3
Consolidated Statements of Shareholders’ Equity for the Three months Ended March 31, 2012 and 2011	4
Consolidated Statements of Cash Flows for the Three months Ended March 31, 2012 and 2011	5
Notes to Consolidated Financial Statements	6
Item 2.  Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations	30
Item 3. Quantitative and Qualitative Disclosures About Market Risk	41
Item 4.  Controls and Procedures	41
Part II.  Other Information
Item 1.  Legal Proceedings	42
Item 1A.  Risk Factors	42
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds	42
Item 6.  Exhibits	42
Signatures
Certifications

Part I. Financial Information

Item 1.  Financial Statements

CITIZENS SOUTH BANKING CORPORATION

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

	March 31, 2012			December 31, 2011 *
(Dollars in thousands, except share and per share data)	(unaudited)
ASSETS
Cash and cash equivalents:
Cash and due from banks	$	12,724		$	13,296
Interest bearing deposits		102,698			75,048
Cash and cash equivalents		115,422			88,344
Investment securities available for sale, at fair value (amortized cost of $20,999 and $51,659 at March 31, 2012 and December 31, 2011, respectively)		20,947			52,136
Investment securities held to maturity, at amortized cost (fair value of $102,226 and $98,115 at March 31, 2012, and December 31, 2011, respectively)		100,464			95,763
Federal Home Loan Bank stock, at cost		5,067			5,067
Presold loans in process of settlement		4,666			2,146
Loans:
Covered by FDIC loss-share agreements		148,833			159,688
Not covered by FDIC loss-share agreements		579,692			574,100
Loans, net of deferred fees and costs		728,525			733,788
Allowance for loan losses		(11,583	)		(11,713	)
Loans, net		716,942			722,075
Other real estate owned		21,352			17,571
Premises and equipment, net		25,671			25,888
FDIC loss share receivable		30,448			38,931
Accrued interest receivable		2,577			2,773
Bank-owned life insurance		18,554			18,978
Intangible assets		1,251			1,373
Other assets		10,454			9,415
Total assets	$	1,073,815		$	1,080,460
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits	$	872,646		$	876,056
Securities sold under repurchase agreements		9,919			9,787
Borrowed money		78,697			78,688
Subordinated debt		15,464			15,464
Other liabilities		7,079			7,806
Total liabilities		983,805			987,801
Shareholders' Equity
Preferred stock, $0.01 par value, Authorized: 1,000,000 shares; Issued and outstanding: 20,500 shares		20,500			20,500
Common stock, $0.01 par value, Authorized: 20,000,000 shares; Issued: 11,561,464 shares; Outstanding: 11,506,324 shares at March 31, 2012 and December 31, 2011		124			124
Additional paid-in-capital		63,941			63,888
Retained earnings, substantially restricted		5,477			7,854
Accumulated other comprehensive income (loss)		(32	)		293
Total shareholders' equity		90,010			92,659
Total liabilities and shareholders' equity	$	1,073,815		$	1,080,460

* Derived from audited consolidated financial statements

See accompanying notes to consolidated financial statements.

1

CITIZENS SOUTH BANKING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

	Three Months Ended March 31,
	2012			2011
(Dollars in thousands, except per share data)
Interest Income:
Interest and fees on loans	$	9,646		$	9,461
Investment securities:
Taxable interest income		736			790
Tax-exempt interest income		38			69
Other interest income		49			67
Total interest income		10,469			10,387
Interest Expense:
Deposits		1,236			2,002
Repurchase agreements		8			18
Borrowed money		669			763
Subordinated debt		103			72
Total interest expense		2,016			2,855
Net interest income		8,453			7,532
Provision for loan losses		6,300			3,000
Net interest income after provision for loan losses		2,153			4,532
Noninterest Income:
Service charges on deposit accounts		1,055			957
Mortgage banking income		317			237
Commissions on sales of financial products		86			67
Income from bank-owned life insurance		184			182
Loss from acquisition		-			(255	)
Gain on sale of investments, available for sale		664			-
Gain (loss) on sale of other assets		(138	)		12
Other		551			278
Total noninterest income		2,719			1,478
Noninterest Expense:
Compensation and benefits		3,846			3,648
Occupancy and equipment		908			828
Data processing and other technology		255			183
Professional services		275			253
Advertising and business development		68			54
Loan collection and other expenses		251			290
Deposit insurance		418			334
Amortization of intangible assets		122			139
Office supplies		60			70
Telephone and communications		106			97
Other real estate owned valuation adjustments		1,000			509
Other real estate owned expenses		469			364
Acquisition and integration expenses		-			45
Other		906			858
Total noninterest expense		8,684			7,672
Loss before income tax benefit		(3,812	)		(1,662	)
Income tax benefit		(1,672	)		(771	)
Net loss		(2,140	)		(891	)
Dividends on preferred stock		122			256
Net loss allocable to common shareholders	$	(2,262	)	$	(1,147	)
Loss per common share - basic	$	(0.20	)	$	(0.10	)
Loss per common share - diluted		(0.20	)		(0.10	)

See accompanying notes to consolidated financial statements.

2

CITIZENS SOUTH BANKING CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)

	Three Months Ended March 31,
	2012			2011
(Dollars in thousands)
Net loss	$	(2,140	)	$	(891	)
Other comprehensive income (loss):
Investment securities, available for sale:
Unrealized holding gains arising during period		135			49
Tax expense		(52	)		(19	)
Reclassification for realized gains included in net income		(664	)		-
Tax benefit		256			-
Other comprehensive income (loss)		(325	)		30
Total comprehensive loss	$	(2,465	)	$	(861	)

See accompanying notes to consolidated financial statements.

3

CITIZENS SOUTH BANKING CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (unaudited)

	Preferred Stock		Common Stock		Additional Paid-in Capital		Retained Earnings, Substantially Restricted			Accumulated Other Comprehensive Income (Loss)			Total Shareholders' Equity
(Dollars in thousands)
Balances, January 1, 2011	$	20,672	$	124	$	63,000	$	9,663		$	(16	)	$	93,443
Net loss		-		-		-		(891	)		-			(891	)
Other comprehensive income, net of tax		-		-		-		-			30			30
Accretion of discount on preferred stock		20		-		-		(20	)		-			-
Allocation from shares purchased with loan to ESOP		-		-		11		-			-			11
Vesting of Recognition and Retention Plan ("RRP")		-		-		25		-			-			25
Stock-based compensation		-		-		28		-			-			28
Cash dividends on preferred stock, net of accretion		-		-		-		(256	)		-			(256	)
Cash dividends on common stock		-		-		-		(114	)		-			(114	)
														-
Balances, March 31, 2011	$	20,692	$	124	$	63,064	$	8,382		$	14		$	92,276
Balances, January 1, 2012	$	20,500	$	124	$	63,888	$	7,854		$	293		$	92,659
Net loss		-		-		-		(2,140	)		-			(2,140	)
Other comprehensive loss, net of tax		-		-		-		-			(325	)		(325	)
Allocation from shares purchased with loan to ESOP		-		-		9		-			-			29
Vesting of RRP		-		-		20		-			-			-
Stock-based compensation		-		-		24		-			-			24
Cash dividends on preferred stock		-		-		-		(122	)		-			(122	)
Cash dividends on common stock		-		-		-		(115	)		-			(115	)
														-
Balances, March 31, 2012	$	20,500	$	124	$	63,941	$	5,477		$	(32	)	$	90,010

See accompanying notes to consolidated financial statements.

4

CITIZENS SOUTH BANKING CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

	Three Months Ended March 31,
	2012			2011
(Dollars in thousands)
Cash flows from operating activities:
Net loss	$	(2,140	)	$	(891	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Provision for loan losses		6,300			3,000
Depreciation of premises and equipment		327			322
Loss on acquisition		-			255
Gain on sale of investment securities available for sale		(664	)		-
(Gain) loss on sale of other real estate owned and repossessed assets		138			(12	)
Valuation adjustment on other real estate owned		1,000			509
Net purchase accounting adjustments		(8,812	)		(2,562	)
Net (increase) decrease in presold loans in process of settlement		(2,520	)		2,779
Deferred loan origination fees		52			60
Amortization of intangible assets		122			139
Allocation of shares to the ESOP		9			11
Stock-based compensation expense		24			28
Vesting of shares issued for the RRP		20			25
Decrease in accrued interest receivable		195			172
(Increase) decrease in other assets		8,059			(6,020	)
Decrease in other liabilities		(725	)		(1,379	)
Net cash provided by (used in) operating activities		1,385			(3,564	)
Cash flows from investing activities:
Net (increase) decrease in loans made to customers		(378	)		11,438
Proceeds from sales of investment securities available for sale		35,520			1,065
Proceeds from sales of other real estate owned		3,064			2,347
Proceeds from maturities/issuer calls of investment securities available for sale		4,115			2,175
Proceeds from maturities/issuer calls of investment securities held to maturity		8,337			3,103
Purchases of investment securities available for sale		(8,311	)		-
Purchases of investment securities held to maturity		(13,038	)		(48,714	)
Purchases of premises and equipment		(110	)		(125	)
Net cash provided by (used in) investment activities		29,199			(28,711	)
Cash flows from financing activities:
Net decrease in deposits		(3,514	)		(17,653	)
Dividends paid to common stockholders		(115	)		(114	)
Dividends paid to preferred stockholders		(122	)		(256	)
Net increase (decrease) in borrowed money and repurchase agreements		141			(3,032	)
Increase in advances from borrowers for insurance and taxes		104			188
Net cash used in financing activities		(3,506	)		(20,867	)
Net increase (decrease) in cash and cash equivalents		27,078			(53,142	)
Cash and cash equivalents at beginning of year		88,344			120,899
Cash and cash equivalents at end of year	$	115,422		$	67,757
Supplemental non-cash investing activity:
Foreclosed loans transferred to other real estate owned	$	7,971		$	4,956

See accompanying notes to consolidated financial statements.

5

CITIZENS SOUTH BANKING CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  In management’s opinion, the accompanying unaudited consolidated financial statements reflect all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the interim financial statements as of and for the three-month periods ended March 31, 2012 and 2011, and have been included as required by Regulation S-X Rule 10-01. They do not include all of the information and footnotes required by such accounting principles for complete financial statements, and therefore should be read in conjunction with the audited consolidated financial statements and accompanying footnotes in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The accompanying unaudited consolidated financial statements include management estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  The more significant estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, other-than-temporary impairments on securities, and the fair value of acquired loans.  Actual results could differ from those estimates.

The accompanying unaudited consolidated financial statements include the accounts of Citizens South Banking Corporation, its wholly-owned subsidiary, Citizens South Bank, and the Bank’s wholly-owned subsidiaries, Citizens South Financial Services, Inc. and Citizens Properties, LLC.  All significant intercompany accounts and transactions have been eliminated in consolidation.Certain of the prior year amounts have been reclassified to conform to current year presentation.  Such reclassifications were immaterial to the financial statements. Results for the three-month period ended March 31, 2012, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2012.

Note 2 - Recent Accounting Pronouncements

A summary of the accounting policies followed by the Company may be found in Note 1 – Organization and Summary of Significant Accounting Policies in the 2011 Annual Report on Form 10-K filed with the SEC.  Updates to the significant accounting policies are reported in the Company’s quarterly reports filed with the SEC on Form 10-Q as new or revised accounting pronouncements are made. The following paragraphs update that information for the first quarter of 2012.

In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11 “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.” ASU 2011-11 requires an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. Retrospective disclosure is required for all comparative periods presented. The Company does not expect an impact on its financial condition or results of operations.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to March 31, 2012. None of these new standards had or is expected to have a material impact on the Company’s consolidated financial statements.

Note 3 – Earnings per Common Share

The Company has presented both basic and diluted earnings per common share (“EPS”).  Basic EPS is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding for the period, without considering any dilutive items.  Diluted EPS is calculated by dividing net income (loss) available to common shareholders by the sum of the weighted average number of common shares outstanding for the period and common stock equivalents for items that are dilutive, net of shares assumed to be repurchased using the treasury method.

6

The potential common stock of the Company includes stock options and unvested shares issued for the Recognition and Retention Plan (“RRP”) granted to various directors and officers of the Bank and unexercised warrants issued to the U.S. Treasury. Due to the net loss during the respective first quarter periods, all for both periods were excluded from the calculation of diluted earnings per share.  The Company excluded 720,270 outstanding options for the three-month period ended March 31, 2012, and 777,313 outstanding options for the three-month period ended March 31, 2011.  In addition, the exercise price of all of these options exceeded the average closing price of the shares of common stock during the respective period and, accordingly would have been anti-dilutive and therefore exluded from the diluted EPS calculation. At March 31, 2011, all of the 450,314 warrants had an exercise price which was in excess of the market value of the stock, so no warrants were included in the calculation of diluted earnings per share for this period since they would have also been anti-dilutive.  There were no warrants outstanding at March 31, 2012.

The following is a reconciliation of the diluted earnings per share calculation for the three-month periods ended March 31, 2012 and 2011:

	Three Months
	Ended March 31,
	2012			2011
	(Dollars in thousands, except per share amounts)
Net loss allocable to common shareholders	$	(2,262	)	$	(1,147	)
Weighted average number of shares outstanding		11,469,525			11,454,919
Basic loss per common share	$	(0.20	)	$	(0.10	)
Net loss allocable to common shareholders	$	(2,262	)	$	(1,147	)
Weighted average number of shares outstanding		11,469,525			11,454,919
Incremental shares from assumed exercise of stock options and warrants		-			-
Weighted average number of shares outstanding - diluted		11,469,525			11,491,734
Diluted loss per common share	$	(0.20	)	$	(0.10	)

7

Note 4 – Investment Securities

The following is a summary of the investment securities portfolio by major classification:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated
	Cost		Gains		Losses		Fair Value
	(Dollars in thousands)
March 31, 2012
Available for sale:
Municipal bonds	$	3,032	$	7	$	-	$	3,039
Mortgage-backed securities		16,316		70		63		16,323
Other securities		1,651		35		101		1,585
Subtotal		20,999		112		164		20,947
Held to maturity:
U.S. Treasury obligations	$	9,977	$	40	$	-	$	10,017
U.S. Government Agency obligations		28,991		17		172		28,836
Municipal bonds		3,286		25		-		3,311
Mortgage-backed securities		49,173		2,106		-		51,279
SBA securities		5,037		-		49		4,988
Other securities		4,000		-		205		3,795
Subtotal		100,464		2,188		426		102,226
Total	$	121,463	$	2,300	$	590	$	123,173

			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated
	Cost		Gains		Losses		Fair Value
	(Dollars in thousands)
December 31, 2011
Available for sale:
U.S. Government Agency obligations	$	7,168	$	73	$	-	$	7,241
Municipal bonds		6,578		133		-		6,711
Mortgage-backed securities		35,170		330		8		35,492
SBA securities		1,255		71		-		1,326
Other securities		1,488		44		166		1,366
Subtotal		51,659		651		174		52,136
Held to maturity:
U.S. Treasury obligations	$	9,972	$	61	$	-	$	10,033
U.S. Government Agency obligations		25,989		74		4		26,059
Municipal bonds		3,300		99		-		3,399
Mortgage-backed securities		52,502		2,277		-		54,779
Other securities		4,000		-		155		3,845
Subtotal		95,763		2,511		159		98,115
Total	$	147,422	$	3,162	$	333	$	150,251

8

The following table sets forth the amount of the fair values and unrealized losses of the investment securities by investment types segregated between those that have been in a continuous unrealized-loss position for less than twelve months and those investments that have been in a continuous unrealized-loss position for more than twelve months at March 31, 2012 and December 31, 2011.  At March 31, 2012, the unrealized losses related to ten U.S Government Agency obligations, three mortgage-backed securities, four corporate bonds and two equity securities.  Of these 19 securities, four have been in a continuous unrealized-loss position for more than 12 months.  At December 31, 2011, the unrealized losses related to one U.S. Government Agency obligation, six mortgage-backed securities and six other securities.  Of these 13 securities, five have been in a continuous unrealized-loss position for more than 12 months.  As of March 31, 2012, and December 31, 2011, management concluded that the unrealized losses presented above were temporary in nature since the unrealized losses were attributable to changes in interest rates and not a deterioration of the credit quality of the issuers.  Also, the Company has the intent and ability to hold these investment securities until maturity or until such unrealized losses are eliminated.

	Less than 12 months				12 months or more				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
	(Dollars in thousands)
March 31, 2012
Available for sale:
Mortgage-backed securities	$	8,263	$	63	$	-	$	-	$	8,263	$	63
Other securities		230		28		29		73		259		101
Subtotal		8,493		91		29		73		8,522		164
Held to maturity:
U.S. Govt. Agency obligations	$	18,824	$	172	$	-	$	-	$	18,824	$	172
SBA Securities		4,988		49		-		-		4,988		49
Other securities		892		108		2,903		97		3,795		205
Subtotal		24,704		329		2,903		97		27,607		426
Total	$	33,197	$	420	$	2,932	$	170	$	36,129	$	590
December 31, 2011
Available for sale:
Mortgage-backed securities	$	4,619	$	8	$	88	$	-	$	4,707	$	8
Other securities		165		93		29		73		194		166
Subtotal		4,784		101		117		73		4,901		174
Held to maturity:
U.S. Government Agency obligations	$	1,996	$	4	$	-	$	-	$	1,996	$	4
Other securities		997		3		2,848		152		3,845		155
Subtotal		2,993		7		2,848		152		5,841		159
Total	$	7,777	$	108	$	2,965	$	225	$	10,742	$	333

From time to time the Company will pledge investment securities as collateral to secure public deposits and for other purposes as required or allowed by law.  The amortized cost of these pledged investment securities was $80.0 million at March 31, 2012 and $82.1 million at December 31, 2011.

9

Note 5 - Loans

The Company makes various business and consumer loans in the normal course of business.  A brief description of these types of loans is as follows:

One-to-four family residential – This portfolio primarily consists of loans secured by residential properties located in the Company’s normal lending area.  These are amortizing loans with either fixed or adjustable rates for terms of 10 to 30 years, including conventional and jumbo loans.  These loans generally have an original loan-to-value ratio (“LTV”) of 80% or less.  Those loans with an initial LTV of more than 80% typically have private mortgage insurance to protect the Company.  This type of loan has historically possessed a lower than average level of loss to the Company.

Multifamily residential – This portfolio is moderately seasoned and is generally secured by multifamily residential properties in the Company’s normal lending area.  These loans generally have an initial LTV of 75% and an initial debt service coverage ratio of 1.2x to 1.0x.  This Company has not experienced any significant losses in this loan portfolio over the past 24 months.

Construction – This portfolio has decreased significantly over the past several years as fewer construction loans have been made during the economic downturn.  These loans are generally located in the Company’s normal lending area and were originated with an initial LTV of 80%.  Approximately 60% of these loans are secured by residential properties and 40% are secured by commercial properties.  This loan portfolio has historically possessed a lower than average loss history compared to the Company’s entire loan portfolio.

Commercial land and residential development – These categories include raw undeveloped land and developed residential lots held by builders and developers.  Generally, the initial LTV for raw land was 65% and the initial LTV for developed lots was 90%.  Given the significant decline in value for both developed and undeveloped land due to reduced demand, these loan portfolios possess a much higher level of risk compared to other loan categories.  These portfolios have experienced the highest level of losses for the Company over the past 24 months.

Other commercial real estate – This portfolio consists of nonresidential improved real estate which includes churches, shopping centers, office buildings, etc.  These loans typically have an initial LTV of 75% and an initial debt service ratio of 1.2x to 1.0x.  Approximately 40% of this portfolio is secured by owner-occupied nonresidential properties.  These properties are generally located in the Company’s normal lending area.  Decreased rental income due to the economic slowdown has caused some deterioration in values.   However, this loan portfolio has historically possessed a lower than average loss history compared to the Company’s entire loan portfolio.

Consumer real estate – This category includes home equity lines of credit (“HELOCs”) and loans secured by residential lots purchased by consumers.  The HELOCs generally have an adjustable rate tied to prime rate and a term of 15 years.  The HELOCs initially had an LTV of up to 85%.  The residential lot loans typically have a term of five years or less and were made at an initial LTV of up to 90%.  Many of these properties have declined in value over the past several years.  The portfolio of consumer lot loans has experienced a higher than average level of loan losses over the past 24 months.  However, the portfolio of HELOCs has experienced a lower than average level of loan losses over the past 24 months.

Commercial business – This category includes loans to small and medium-sized businesses that are not secured by real estate.  These loans are typically secured by accounts receivable, inventory, equipment, etc.  These loans are typically granted to local businesses that have a strong track record of profitability and performance.  This category of loans incurred slightly lower than average losses for the Company over the past 24 months.

Other consumer - These loans are either unsecured or secured by automobiles, marketable securities, etc.  They are generally granted to local customers that have an established banking relationship with our Bank.  The loss history for this category of loans has been lower than the Company average over the past 24 months.

10

The following is a summary of loans outstanding by category at the periods presented:

	March 31, 2012						December 31, 2011
	Loans covered by FDIC loss share agreements		Loans not covered by FDIC loss share agreements		Total		Loans covered by FDIC loss share agreements		Loans not covered by FDIC loss share agreements		Total
	(Dollars in thousands)
Real estate:
One-to-four family residential	$	31,998	$	115,418	$	147,416	$	34,641	$	116,859	$	151,500
Multifamily residential		2,893		16,977		19,870		2,926		16,759		19,685
Construction		34		18,517		18,551		1,255		19,602		20,857
Commercial land		12,242		23,378		35,620		13,670		28,122		41,792
Residential development		7,999		12,218		20,217		8,095		16,444		24,539
Owner occupied commercial real estate		20,125		106,798		126,923		20,027		95,990		116,017
Non-owner occupied commercial real estate		53,872		135,523		189,395		56,285		129,993		186,278
Consumer real estate		10,682		101,019		111,701		11,148		103,521		114,669
Total real estate		139,845		529,848		669,693		148,047		527,290		675,337
Commercial business		5,767		43,878		49,645		7,866		41,161		49,027
Other consumer		3,221		5,966		9,187		3,775		5,649		9,424
Total loans	$	148,833	$	579,692		728,525	$	159,688	$	574,100		733,788
Less: Allowance for loan losses						11,583						11,713
Total net loans					$	716,942					$	722,075

The Company, through its normal lending activity, originates substantially all of its loans to borrowers that are located in the Piedmont (central) Region of North and South Carolina and the North Georgia Region. The Company also has presold loans in process of settlement which totaled $4.7 million at March 31, 2012, and $2.1 million at December 31, 2011.  These presold loans in process of settlement were not included in the table above.

As of March 31, 2012, the Company had $148.8 million in loans covered by FDIC loss-share agreements as a result of the acquisition of loans from Bank of Hiawassee and New Horizons Bank in separate FDIC-assisted transactions (referred to as “covered loans”).  The loans acquired in the Bank of Hiawassee transaction in March 2010 are covered by two loss-share agreements between the FDIC and the Bank, which afford the Bank significant protection against future loan losses.  Under these loss-share agreements, the FDIC will cover 80% of net loan losses up to $102 million and 95% of net loan losses that exceed $102 million.  The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans and five years for losses and eight years on recoveries on nonresidential loans. At acquisition, the Bank recorded an estimated receivable from the FDIC in the amount of $36.3 million, which represented the discounted value of the FDIC’s estimated portion of the expected future loan losses.  New loans made after the acquisition date are not covered by the FDIC loss-share agreements. These covered loans totaled $108.5 million at March 31, 2012.

In April 2011 the Company acquired New Horizons Bank in an FDIC-assisted transaction.  As part of this transaction, the Company acquired $49.3 million in loans at fair value. Of the acquired loans, $47.4 million are covered by two loss-share agreements between the FDIC and the Bank.  Under these loss-share agreements, the FDIC will cover 80% of net loan losses and qualified expenses.  The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans and five years for losses and eight years on recoveries on nonresidential loans. At acquisition, the Bank recorded an estimated receivable from the FDIC in the amount of $19.9 million, which represented the discounted value of the FDIC’s estimated portion of the expected future loan losses.  The remaining $1.9 million in loans acquired in the New Horizons Bank transaction were not covered by FDIC loss-share agreements.  As such, any losses incurred on these non-covered loans will be the sole responsibility of the Bank. New loans made after the acquisition date are not covered by the FDIC loss-share agreements. These covered loans totaled $40.3 million at March 31, 2012.

11

A portion of the fair value discount on the acquired loans has an accretable yield associated with those loans that is accreted into interest income over the estimated remaining life of the loans.  The remaining nonaccretable difference represents cash flows not expected to be collected.  The changes in the accretable yield and the carrying amounts of the covered loans for the three months ended March 31, 2012 and 2011 are presented in the following table.

	Three Months Ended						Three Months Ended
	March 31, 2012						March 31, 2011
	Net Accretable Yield			Carrying Amount			Net Amortizable Premium			Carrying Amount
	(in thousands)						(in thousands)
Balance at beginning of period	$	220		$	159,688		$	(1,050	)	$	147,576
Additions due to acquisition		-			-			-			-
Reductions from payments and foreclosures, net		210			(10,502	)		-			(9,825	)
(Accretion)/Amortization		(353	)		(353	)		7			7
Balance at end of period	$	77		$	148,833		$	(1,043	)	$	137,758

12

Note 6 – Credit Quality of Loans

Loan Payment Status.  The following tables present an aging analysis of the Company’s past due loans by loan category at March 31, 2012 and December 31, 2011.

March 31, 2012	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due and Accruing		Nonaccrual		Total Past Due		Current		Total Loans		Recorded Investment 90 Days or More and Accruing
(Dollars in thousands)
Not covered by FDIC loss-share agreements:
Real estate:
One-to-four family residential	$	1,036	$	754	$	-	$	2,698	$	4,488	$	110,930	$	115,418	$	-
Multifamily residential		-		-		-		-		-		16,977		16,977		-
Construction		-		-		-		-		-		18,517		18,517		-
Commercial land		592		111		-		3,852		4,555		18,823		23,378		-
Residential development		-		182		-		3,742		3,924		8,294		12,218		-
Other commercial real estate		1,780		256		-		8,924		10,960		231,361		242,321		-
Consumer real estate		572		48		-		1,710		2,330		98,689		101,019		-
Total real estate		3,980		1,351		-		20,926		26,257		503,591		529,848		-
Commercial business		22		-		-		1,086		1,108		42,770		43,878		-
Other consumer		1		8		-		40		49		5,917		5,966		-
Total	$	4,003	$	1,359	$	-	$	22,052	$	27,414	$	552,278	$	579,692	$	-
Covered by FDIC loss-share agreements:
Real estate:
One-to-four family residential	$	345	$	130	$	166	$	9,289	$	9,930	$	22,068	$	31,998	$	167
Multifamily residential		-		-		-		216		216		2,677		2,893		-
Construction		-		-		-		-		-		34		34		-
Commercial land		-		-		-		5,874		5,874		6,368		12,242		-
Residential development		189		87		75		4,420		4,771		3,228		7,999		77
Other commercial real estate		476		1,223		-		17,479		19,178		54,819		73,997		-
Consumer real estate		93		66		-		588		747		9,935		10,682		-
Total real estate		1,103		1,506		241		37,866		40,716		99,129		139,845		244
Commercial business		53		-		216		1,666		1,935		3,832		5,767		218
Other consumer		60		4		-		593		657		2,564		3,221		-
Total	$	1,216	$	1,510	$	457	$	40,125	$	43,308	$	105,525	$	148,833	$	462
Total at March 31, 2012:
Real estate:
One-to-four family residential	$	1,381	$	884	$	166	$	11,987	$	14,418	$	132,998	$	147,416	$	167
Multifamily residential		-		-		-		216		216		19,654		19,870		-
Construction		-		-		-		-		-		18,551		18,551		-
Commercial land		592		111		-		9,726		10,429		25,191		35,620		-
Residential development		189		269		75		8,162		8,695		11,522		20,217		77
Other commercial real estate		2,256		1,479		-		26,403		30,138		286,180		316,318		-
Consumer real estate		665		114		-		2,298		3,077		108,624		111,701		-
Total real estate		5,083		2,857		241		58,792		66,973		602,720		669,693		244
Commercial business		75		-		216		2,752		3,043		46,602		49,645		218
Other consumer		61		12		-		633		706		8,481		9,187		-
Total	$	5,219	$	2,869	$	457	$	62,177	$	70,722	$	657,803	$	728,525	$	462

13

December 31, 2011	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due and Accruing		Nonaccrual		Total Past Due		Current		Total Loans		Recorded Investment 90 Days or More and Accruing
(Dollars in thousands)
Not covered by FDIC loss-share agreements:
Real estate:
One-to-four family residential	$	80	$	1,634	$	-	$	2,407	$	4,121	$	112,738	$	116,859	$	-
Multifamily residential		-		-		-		-		-		16,759		16,759		-
Construction		-		93		-		-		93		19,509		19,602		-
Commercial land		-		-		-		2,631		2,631		25,491		28,122		-
Residential development		-		-		-		6,474		6,474		9,970		16,444		-
Other commercial real estate		81		1,873		-		4,173		6,127		219,856		225,983		-
Consumer real estate		761		388		335		2,543		4,027		99,494		103,521		338
Total real estate		922		3,988		335		18,228		23,473		503,817		527,290		338
Commercial business		7		-		-		168		175		40,986		41,161		-
Other consumer		13		3		-		80		96		5,553		5,649		-
Total	$	942	$	3,991	$	335	$	18,476	$	23,744	$	550,356	$	574,100	$	338
Covered by FDIC loss-share agreements:
Real estate:
One-to-four family residential	$	1,530	$	2,220	$	215	$	8,441	$	12,406	$	22,235	$	34,641	$	219
Multifamily residential		-		-		-		216		216		2,710		2,926		-
Construction		-		-		-		1,191		1,191		64		1,255		-
Commercial land		140		11		10		6,704		6,865		6,805		13,670		11
Residential development		-		-		-		4,578		4,578		3,517		8,095		-
Other commercial real estate		351		466		495		17,454		18,766		57,546		76,312		511
Consumer real estate		236		15		-		634		885		10,263		11,148		-
Total real estate		2,257		2,712		720		39,218		44,907		103,140		148,047		741
Commercial business		90		39		23		3,484		3,636		4,230		7,866		24
Other consumer		141		133		57		554		885		2,890		3,775		58
Total	$	2,488	$	2,884	$	800	$	43,256	$	49,428	$	110,260	$	159,688	$	823
Total at December 31, 2011:
Real estate:
One-to-four family residential	$	1,610	$	3,854	$	215	$	10,848	$	16,527	$	134,973	$	151,500	$	219
Multifamily residential		-		-		-		216		216		19,469		19,685		-
Construction		-		93		-		1,191		1,284		19,573		20,857		-
Commercial land		140		11		10		9,335		9,496		32,296		41,792		11
Residential development		-		-		-		11,052		11,052		13,487		24,539		-
Other commercial real estate		432		2,339		495		21,627		24,893		277,402		302,295		511
Consumer real estate		997		403		335		3,177		4,912		109,757		114,669		338
Total real estate		3,179		6,700		1,055		57,446		68,380		606,957		675,337		1,079
Commercial business		97		39		23		3,652		3,811		45,216		49,027		24
Other consumer		154		136		57		634		981		8,443		9,424		58
Total	$	3,430	$	6,875	$	1,135	$	61,732	$	73,172	$	660,616	$	733,788	$	1,161

14

Troubled Debt Restructurings.  The Company adopted the amendments in Accounting Standards Update (“ASU”) No. 2011-02 Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, during the quarter ended September 30, 2011, and has reassessed all restructurings that occurred on or after the beginning of the 2011 fiscal year for identification as troubled debt restructurings (“TDRs”). The Company identified as TDRs certain receivables for which the allowance for credit losses had previously been measured under a general allowance for credit losses methodology (ASC 450-20). Upon identifying the reassessed receivables as TDRs, the Company also identified them as impaired under the new guidance in ASC 310-10-35. The amendments in ASU No. 2011-02 require prospective application of the impairment measurement guidance in Section 310-10-35 for those receivables newly identified as impaired. At the end of the first interim period of adoption for the Company, the recorded investment in the receivables for which the allowance for credit losses was previously measured under a general allowance for credit losses methodology and are now impaired under Section 310-10-35 was $1.3 million (310-40-65-1(b)), and there was no allowance for credit losses associated with those receivables, on the basis of a current evaluation of loss (310-40-65-1(b)).

The modification or restructuring of a debt constitutes a TDR if we, for economic or legal reasons related to the borrower’s financial difficulties, grant a concession to the borrowers that we would not otherwise consider. Some examples of modifications are described below:

Rate modification –  A modification in which only the interest rate is changed.

Term modification – A modification in which the maturity date, timing of payments, or frequency of payments is changed.

Interest only modification – A modification in which the loan is converted to interest only payments for a period of time.

Debt Reduction Modification – A modification in which a portion of the debt is reduced.

Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

Transfer of Assets Modification– A modification in which a transfer of assets has occurred to partially satisfy debt, including foreclosure and repossession.

Combination Modification – Any other type of modification, including the use of multiple categories above.

15

The following tables present the Bank’s loans classified as TDRs by loan type as of March 31, 2012 and December 31, 2011:

	March 31, 2012
	Accrual Status		Non-accrual Status		Total Contracts		Total TDRs
	(Dollars in thousands)
One-to-four family residential	$	12	$	-	$	1	$	12
Commercial land		884		685		3		1,569
Residential development		-		143		1		143
Consumer real estate		3,927		3,347		24		7,274
Commercial business		-		921		1		921
Total	$	4,823	$	5,096	$	30	$	9,919

	December 31, 2011
	Accrual Status		Non-accrual Status		Total Contracts		Total TDRs
	(Dollars in thousands)
One-to-four family residential	$	12	$	-		1	$	12
Commercial land		195		89		2		284
Residential development		633		-		2		633
Other commercial real estate		6,955		1,159		24		8,114
Total	$	7,795	$	1,248	$	29	$	9,043

16

The following tables present newly restructured loans that occurred during the three months ended March 31, 2012 and March 31, 2011, respectively:

	Three Months Ended						Three Months Ended
	March 31, 2012						March 31, 2011
	Total Number of Contracts		Pre-modification Outstanding Recorded Investment		Post-modification Outstanding Recorded Investment		Total Number of Contracts		Pre-modification Outstanding Recorded Investment		Post-modification Outstanding Recorded Investment
(Dollars in thousands)
Interest only modification:
Commercial real estate		-		-		-		1		145		145
Subtotal		-	$	-	$	-		1	$	145	$	145
Term modification:
Commercial business		-		-		-		2		17		17
Subtotal		-	$	-	$	-		2	$	17	$	17
Debt reduction reduction:
Commercial land		2	$	2,357	$	1,366		-	$	-	$	-
Subtotal		2	$	2,357	$	1,366		-	$	-	$	-
Total		2	$	2,357	$	1,366		3	$	162	$	162

All TDRs are not automatically placed on nonaccrual status.  Generally, those TDRs that are placed on non-accrual status may return to accrual status when the borrower has sustained repayment performance in accordance with the modified terms.  The number of payments needed to meet these criteria varies from loan to loan.  However, as a general rule, most non-accrual loans should be able to return to accrual status after the payment of six consecutive regular scheduled payments. During the three month period ended March 31, 2012, there were no payment defaults on any TDRs.  During the 12 month period ended December 31, 2011, there was one payment default on a residential TDR.  The collateral for this residential loan was acquired through foreclosure and was sold during the third quarter of 2011.  The loan had an original principal balance of $1.1 million and the resulting loss from disposition of the collateral was approximately $335,000.

Also, in the normal course of business, the Company will make loan restructurings or modifications to borrowers for reasons unrelated to the borrower’s financial condition.  These restructurings or modifications are made based on the prevailing interest rates and terms offered to other borrowers for similar types of loans at the time of the modification. These types of debt restructurings or loan modifications would not be considered troubled debt restructurings.

Impaired Loans.  The Company evaluates impairment of its non-covered residential mortgage and consumer loans on a collective basis, while non-covered commercial and construction loans are evaluated individually for impairment.  The Company identifies a non-covered loan as impaired when it is probable that principal and interest will not be collected when due according to the contractual terms of the loan agreement.  Specific allowances or principal write-downs are established for certain individual non-covered loans that management considers impaired.  The remainder of the portfolio of non-covered loans is segmented into groups of loans with similar risk characteristics for evaluation and analysis.

17

The following table details the Company’s impaired loans at March 31, 2012 and December 31, 2011:

	Recorded Investment		Unpaid Principal Balance		Principal  Write-down		Net Principal Balance
	(Dollars in thousands)
March 31, 2012
One-to-four family residential	$	3,171	$	3,581	$	545	$	3,036
Commercial land		4,018		5,052		1,200		3,852
Residential development		4,537		6,492		2,186		4,306
Commercial real estate - office		8,603		9,632		1,134		8,498
Commercial real estate - residential rental		4,151		5,501		1,472		4,029
Commercial real estate - owner-occupied		3,693		4,394		797		3,597
Commercial real estate - other		639		790		170		620
Consumer real estate		2,304		3,363		1,240		2,123
Commercial business		1,137		1,670		551		1,119
Other consumer		47		45		-		45
Total impaired loans	$	32,300	$	40,520	$	9,295	$	31,225
December 31, 2011
One-to-four family residential	$	2,781	$	2,739	$	-	$	2,739
Commercial land		3,062		4,523		1,697		2,826
Residential development		8,428		10,173		1,911		8,262
Commercial real estate - office		6,322		7,573		1,268		6,305
Commercial real estate - residential rental		4,076		4,808		779		4,029
Commercial real estate - other		2,426		2,945		622		2,323
Consumer real estate		2,689		2,801		171		2,630
Commercial business		169		169		-		169
Other consumer		89		90		1		89
Total impaired loans	$	30,042	$	35,821	$	6,449	$	29,372

Loan Classification. We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debts such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  We analyze loans individually by classifying the loans as to credit risk.  This analysis is performed on at least a quarterly basis.  We use the following definitions for risk ratings: Special Mention - Loans classified as special mention have a potential weakness that deserves management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of our credit position at some future date. Substandard -  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified have one or more well-defined weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Doubtful -  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values highly questionable and improbable.  Loss – Loans classified as loss are considered to be completely uncollectable and as a result the loans have been completely written-off the books of the Company. Loans not meeting the criteria above as part of the above described process are considered to be Pass rated loans.   The Company’s portfolio of FDIC-covered loans was considered to be Pass rated loans at March 31, 2012 and December 31, 2011, as the loans were marked to fair value at acquisition and have FDIC loss-share agreements to cover at least 80% of any future losses.

18

As of March 31, 2012 and December 31, 2011, the risk category of loans is as follows:

			Criticized Loans
March 31, 2012	Pass		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Real estate:
One-to-four family residential	$	143,058	$	726	$	3,632	$	-	$	147,416
Multifamily residential		19,343		527		-		-		19,870
Construction		18,551		-		-		-		18,551
Commercial land		27,833		1,168		6,619		-		35,620
Residential development		14,117		894		5,206		-		20,217
Other commercial real estate		279,073		24,435		12,810		-		316,318
Consumer land		16,977		202		904		-		18,083
Home equity lines of credit		91,151		738		1,729		-		93,618
Total real estate		610,103		28,690		30,900		-		669,693
Commercial business		48,212		248		1,185		-		49,645
Other consumer		8,957		168		61		1		9,187
Total loans	$	667,272	$	29,106	$	32,146	$	1	$	728,525

			Criticized Loans
December 31, 2011	Pass		Special Mention		Substandard		Doubtful		Total
	(Dollars in thousands)
Real estate:
One-to-four family residential	$	149,013	$	562	$	1,925	$	-	$	151,500
Multifamily residential		19,685		-		-		-		19,685
Construction		20,857		-		-		-		20,857
Commercial land		30,202		8,600		2,990		-		41,792
Residential development		15,806		1,037		7,696		-		24,539
Other commercial real estate		269,970		19,925		12,400		-		302,295
Consumer land		17,356		458		1,560		-		19,374
Home equity lines of credit		92,752		790		1,753		-		95,295
Total real estate		615,641		31,372		28,324		-		675,337
Commercial business		48,477		254		296		-		49,027
Other consumer		9,147		170		107		-		9,424
Total loans	$	673,265	$	31,796	$	28,727	$	-	$	733,788

19

Note 7 - Allowance for Loan Losses

The Company has established a systematic methodology for determining the allowance for loan losses.  This methodology is set forth in a formal policy and considers all non-covered loans in the portfolio.  Loans totaling $148.8 million that were covered under the FDIC loss-share agreements were not included in the Company’s evaluation of the adequacy of loan loss allowances since potential losses are covered up to at least 80% by the FDIC.  These covered loans were recorded at their estimated fair value at the time of the acquisition.  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 collectability. The allowance for loan losses is increased by charging provisions for loan losses against income.  As of March 31, 2012, the allowance for loan losses was $11.6 million, or 2.0% of total non-covered loans.  Management believes that this amount meets the requirement for losses that are inherent in the non-covered loan portfolio.  Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations.

A reconciliation of the allowance for loan losses is as follows:

	Three Months
	Ended March 31,
	2012			2011
	(Dollars in thousands)
Balance - Beginning of period	$	11,713		$	11,924
Charge-offs:
One-to-four family residential		(899	)		(825	)
Construction		-			(36	)
Commercial land		(90	)		(899	)
Residential development		(2,492	)		(1,054	)
Other commercial real estate		(1,381	)		(16	)
Consumer real estate		(1,730	)		(56	)
Commercial business		-			(153	)
Other consumer		(11	)		(13	)
Total charge-offs		(6,603	)		(3,052	)
Recoveries:
One-to-four family residential		33			3
Construction		-			50
Commercial land		-			-
Residential development		57			-
Other commercial real estate		78			-
Consumer real estate		2			7
Commercial business		2			3
Other consumer		1			71
Total recoveries		173			134
Provision for loan losses		6,300			3,000
Balance - End of period	$	11,583		$	12,006

20

The following tables present a disaggregated analysis of the activity in the allowance for loan losses and loan balances for non-covered loans for the three months ended March 31, 2012 and March 31, 2011.

(Dollars in thousands)	One-to-four family residential			Multifamily residential		Construction			Commercial land			Residential development			Other commercial real estate			Consumer real estate			Commercial business		Other consumer			Total
March 31, 2012
Allowance for loan losses:
Balance - January 1, 2012	$	500		$	150	$	800		$	2,334		$	1,999		$	1,830		$	1,600		$	2,000	$	500		$	11,713
Charge-offs		(899	)		-		-			(90	)		(2,492	)		(1,381	)		(1,730	)		-		(11	)		(6,603	)
Recoveries		33			-		-			-			57			78			2			2		1			173
Provision		900			-		(150	)		100			2,500			1,400			1,500			-		50			6,300
Balance - March 31, 2012	$	534		$	150	$	650		$	2,344		$	2,064		$	1,927		$	1,372		$	2,002	$	540		$	11,583
Loans individually evaluated for impairment	$	-		$	-	$	-		$	-		$	-		$	-		$	-		$	-	$	-		$	-
Loans collectively evaluated for impairment	$	534		$	150	$	650		$	2,344		$	2,064		$	1,927		$	1,372		$	2,002	$	540		$	11,583
Loans:
Loans individually evaluated for impairment	$	3,036		$	-	$	-		$	3,852		$	4,306		$	16,744		$	2,123		$	1,119	$	45		$	31,225
Loans collectively evaluated for impairment		112,382			16,977		18,517			19,526			7,912			225,577			98,896			42,759		5,921			548,467
Total non-covered loans	$	115,418		$	16,977	$	18,517		$	23,378		$	12,218		$	242,321		$	101,019		$	43,878	$	5,966		$	579,692

(Dollars in thousands)	One-to-four family residential			Multifamily residential		Construction			Commercial land			Residential development			Other commercial real estate			Consumer real estate			Commercial business			Other consumer			Total
March 31, 2011
Allowance for loan losses:
Balance - January 1, 2011	$	500		$	200	$	1,000		$	2,163		$	2,000		$	1,561		$	1,500		$	2,500		$	500		$	11,924
Charge-offs		(825	)		-		(36	)		(899	)		(1,054	)		(16	)		(56	)		(153	)		(13	)		(3,052	)
Recoveries		3			-		50			-			-			-			7			3			71			134
Provision		850			-		-			750			1,050			100			100			150			-			3,000
Balance - March 31, 2011	$	528		$	200	$	1,014		$	2,014		$	1,996		$	1,645		$	1,551		$	2,500		$	558		$	12,006
Loans individually evaluated for impairment	$	-		$	-	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-
Loans collectively evaluated for impairment	$	528		$	200	$	1,014		$	2,014		$	1,996		$	1,645		$	1,551		$	2,500		$	558		$	12,006
Loans:
Loans individually evaluated for impairment	$	630		$	-	$	225		$	3,857		$	5,180		$	7,551		$	151		$	-		$	-		$	17,594
Loans collectively evaluated for impairment		108,732			20,291		18,758			31,239			18,051			226,692			106,220			34,020			5,300			569,303
Total non-covered loans	$	109,362		$	20,291	$	18,983		$	35,096		$	23,231		$	234,243		$	106,371		$	34,020		$	5,300		$	586,897

21

Note 8 – FDIC Loss Share Receivable

The following table details changes in the loss share receivable from the FDIC for the three months ended March 31, 2012 and March 31, 2011.

	Three Months
	Ended March 31,
	2012			2011
	(in thousands)
Balance at beginning of period	$	38,931		$	24,848
Increase in expected losses on indemnified assets		996			1,222
Claimable net losses on OREO covered under loss share agreements		789			183
Reimbursable expenses claimed		507			125
Accretion of discounts and premiums, net		(917	)		(717	)
Receipt of payments from FDIC		(9,858	)		(142	)
Other		-			92
Balance at end of period	$	30,448		$	25,611

Note 9 – Deposits

Deposit balances and average rates are detailed by category in the following table for the respective periods:

	March 31, 2012					December 31, 2011
	Amount		Average Rate			Amount		Average Rate
(Dollars in thousands)
Noninterest-bearing demand	$	97,437		0.00	%	$	88,077		0.00	%
Interest-bearing demand		200,675		0.21	%		199,390		0.41	%
Money market deposit		155,599		0.31	%		155,228		0.52	%
Savings accounts		22,147		0.16	%		20,542		0.17	%
Time deposits		396,788		1.00	%		412,819		1.26	%
Total deposits	$	872,646		0.64	%	$	876,056		0.81	%

Note 10 – Preferred Stock

On September 22, 2011, the Company entered into a Securities Purchase Agreement with the Secretary of the United States Department of the Treasury (“Treasury”), pursuant to which the Company issued and sold to the Treasury 20,500 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (“Series C Preferred Stock”), having a liquidation preference of $1,000 per share, for aggregate proceeds of $20,500,000.    The Securities Purchase Agreement was entered into, and the Series C Preferred Stock was issued, pursuant to the Treasury’s Small Business Lending Fund program (“SBLF”), as established under the Small Business Jobs Act of 2010.   The Company’s rights and obligations with respect to the Series C Preferred Stock are set forth in the Securities Purchase Agreement and the Certificate of Designation to its Certificate of Incorporation filed by the Company with the Secretary State of the State of Delaware. The Series C Preferred Stock is entitled to receive non-cumulative dividends payable quarterly.  The dividend rate was initially set at 4.84% per annum based upon the initial level of qualified small business lending (“QSBL”) by the Bank.  The dividend rate for future dividend periods will be set based upon the percentage change in the QSBL between each dividend period and the baseline QSBL level.  This dividend rate may vary from 1% per annum to 5% per annum for the second through tenth dividend periods, from 1% per annum to 7% per annum for the eleventh through the first half of the nineteenth dividend periods.  The current dividend rate is 1.3%.  If the Series C Preferred Stock remains outstanding for more than four-and-one-half years, the dividend rate will be fixed at 9%.  Prior to that time the dividend rate decreases as the level of the Bank’s QSBL increases.  Also, the Company may redeem the shares of Series C Preferred Stock, in whole or in part, at any time subject to prior approval by the Company’s primary federal banking regulator.

22

As a result of the Company’s participation in SBLF, the Company redeemed all 20,500 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A it sold to the Treasury on December 12, 2008, in connection with the Treasury’s Capital Purchase Program.  The Company paid $20.6 million to the Treasury to redeem the Series A Preferred Stock, which includes the original investment of $20.5 million, plus accrued dividends.

Note 11 – Commitments

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

Commitments to extend credit at the respective periods are detailed in the following table.

	March 31, 2012		December 31, 2011
(Dollars in thousands)
Loan commitments
Residential mortgage loans	$	13,068	$	24,484
Total loan commitments	$	13,068	$	24,484
Unused lines of credit
Residential construction	$	7,562	$	7,390
Commercial real estate		17,865		18,593
Commercial business		11,801		9,558
Consumer		75,115		74,930
Total unused lines of credit	$	112,343	$	110,471
Undisbursed Construction Loan Proceeds	$	795	$	1,200

23

Note 12 – Fair Value Measurements

The Company records certain assets at fair value. The Company has not elected the fair value option for liabilities.  Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets, to perform impairment assessments, and for disclosure purposes.  The Company uses quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

Fair value measurements are classified within one of three levels based on the observability of the inputs used to determine fair value, as follows:

Level 1 — The valuation is based on quoted prices in active markets for identical instruments.

Level 2 — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument.  Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Investment securities available for sale and rabbi trusts, are recorded at fair value on a recurring basis.  Additionally, the Company records at fair value other assets on a nonrecurring basis, including presold loans in process of settlement, impaired loans, and other real estate owned.  These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting for these other assets.

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

Financial Instruments on a Recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a recurring basis:

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

24

The table below presents the balance of assets at March 31, 2012 and December 31, 2011 measured at fair value on a recurring basis:

	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
March 31, 2012
Investment securities, available for sale:
Municipal bonds	$	-	$	2,839	$	200	$	3,039
Mortgage-backed bonds		-		16,323		-		16,323
Equity securities		-		-		1,585		1,585
Total	$	-	$	19,162	$	1,785	$	20,947
December 31, 2011
Investment securities, available for sale:
U.S. Government Agency obligations	$	-	$	7,241	$	-	$	7,241
Municipal bonds		-		6,511		200		6,711
Mortgage-backed bonds		-		35,492		-		35,492
SBA securities		-		1,326		-		1,326
Equity securities		-		-		1,366		1,366
Total	$	-	$	50,570	$	1,566	$	52,136

The changes in Level 3 assets measured at fair value on a recurring basis for the quarter ended March 31, 2012 and March 31, 2011 are shown in the following table:

	2012		2011
	(Dollars in thousands)
Beginning balance, January 1	$	1,567	$	3,023
Total gains included in:
Other comprehensive income		55		26
Sales		-		(1,065	)
Transfers in		163		-
Ending balance, March 31	$	1,785	$	1,984

The 2012 purchases totaling $163,000 represents capital calls for two Small Business Investment Company investments. The 2011 sales totaling $1,065,000 represents the sale of corporate bonds that were not traded on an active exchange.

25

Financial Instruments on a Non-recurring Basis:

The following is a description of the valuation methodologies used for financial instruments measured at fair value on a non-recurring basis:

Investment Securities – Investment securities, held to maturity, are recorded at amortized cost.  Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  Level 1 fair value is used for those securities traded on an active exchange, U.S. Treasury securities that are traded by brokers or dealers in an active over-the-counter market, and money market funds.  Level 2 securities include mortgage-backed securities issued by government-sponsored enterprises, municipal bonds, and corporate debt securities.  These Level 2 securities are valued using an independent third party.  This independent third party uses multiple pricing vendors and matrix pricing methods developed in accordance with the Securities Industry and Financial Markets Association’s industry-standard methods.  Level 3 investment securities include equity securities that are not traded on an active exchange, investments in closely held subsidiaries, and asset-backed securities traded in less liquid markets.

Presold Loans in Process of Settlement - The Company does not record all loans at fair value on a recurring basis.  However, loans that have been presold and are in the process of settlement are recorded at their fair value.  These presold loans are recorded as nonrecurring Level 2 since there is a firm commitment by a qualified third party to purchase the loans within a 90 day period.

Impaired Loans - Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered to be impaired. Once a loan is identified as being impaired, management measures the impairment in accordance with ASC 310-10-35. The fair value of impaired loans is estimated using one of several methods, including collateral value, market price and discounted cash flows. When the fair value of the collateral was based on an observable market price, the Company recorded the impaired loan as nonrecurring Level 2. When an observable market price was not available or when management made assumptions that impact the fair value of the collateral, such as estimated disposition or holding costs, the Company recorded the impaired loan as nonrecurring Level 3. Management has determined that the fair value of the Company’s impaired loans used Level 3 methodology.  For substantially all of the Company’s impaired loans as of March 31, 2012 and December 31, 2011, the valuation methodology utilized by the Company was collateral based measurements such as a real estate appraisal and the discount to reflect current market conditions and ultimately collectability ranged from 0% to 20% for each of the respective periods.

Other Real Estate Owned - Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price, the Company records the foreclosed asset as nonrecurring Level 2. When an observable market price is not available, or when management makes assumptions that impact the fair value of the collateral, such as estimated disposition or holding costs, the Company records the other real estate owned as nonrecurring Level 3. For substantially all of the Company’s foreclosed assets as of March 31, 2012 and December 31, 2011, the valuation methodology utilized by the Company was collateral based measurements such as a real estate appraisal and the discount to reflect current market conditions ranged from 0% to 20% for each of the respective periods.

26

The table below presents the balance of assets at March 31, 2012 and December 31, 2011 measured at fair value on a recurring basis:

	Level 1		Level 2		Level 3		Total
	(Dollars in thousands)
March 31, 2012
Investment securities, held to maturity
U.S. Treasury obligations	$	10,017	$	-	$	-	$	10,017
U.S. Government Agency obligations		-		28,836		-		28,836
Municipal bonds		-		3,311		-		3,311
Mortgage-backed bonds		-		51,279		-		51,279
SBA securities		-		4,988		-		4,988
Corporate bonds		-		3,795		-		3,795
Presold loans in process of settlement		-		4,666		-		4,666
Impaired loans		-		-		31,225		31,225
Other real estate owned		-		-		21,352		21,352
Total	$	10,017	$	96,875	$	52,577	$	159,469
December 31, 2011
Investment securities, held to maturity
U.S. Treasury obligations	$	10,033	$	-	$	-	$	10,033
U.S. Government Agency obligations		-		26,059		-		26,059
Municipal bonds		-		3,399		-		3,399
Mortgage-backed bonds		-		54,779		-		54,779
Corporate bonds		-		3,845		-		3,845
Presold loans in process of settlement		-		2,146		-		2,146
Impaired loans		-		-		29,372		29,372
Other real estate owned		-		-		17,571		17,571
Total	$	10,033	$	90,228	$	46,943	$	147,204

Note 13 - Fair Value of Financial Instruments

Estimated fair values of financial instruments have been estimated by the Company using the provisions of ASC Topic 825, Financial Instruments “ASC 825”, which requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments.  ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.  The following methods and assumptions were used to estimate the fair value of financial instruments:

Cash and noninterest-bearing deposits - The carrying amounts reported in the balance sheets for cash and noninterest-bearing deposits approximate the fair value of those assets.

Interest-earning bank balances - The carrying amounts reported in the balance sheets for interest-earning deposits approximate the fair value of those assets.

27

Investment securities - Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on readily available pricing sources for market transactions involving comparable types of investments in active markets.

Federal Home Loan Bank stock - The fair values for FHLB stock are its carrying value since this is the amount for which it could be redeemed. There is no active market for this stock and the Company, in order to be a member of the FHLB, is required to maintain a minimum investment.

Presold loans in process of settlement – The fair values of presold loans in process of settlement are its carrying value since these loans have a firm commitment to be purchased by an independent third party.

Loans receivable, net - The fair values for fixed rate loans are estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms and credit ratings for the same remaining maturities. The fair value of variable rate loans that reprice frequently is based on the carrying value.  The resulting fair value for fixed and variable rate loans is adjusted for the allowance for loan losses.

FDIC loss share receivable - The fair values for the FDIC indemnification asset are estimated based on discounted future cash flows using current discount rates.

Accrued interest receivable and Accrued interest payable - The carrying values of accrued interest receivable and accrued interest payable are assumed to approximate fair value.

Bank-owned life insurance - The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer.

Demand deposits, money market accounts and savings accounts - The fair values of demand deposits, money market accounts and savings accounts are equal to the amount payable on demand at the reporting date.

Time deposits – The fair values for time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on these accounts to a schedule of aggregated expected monthly maturities on time deposits.

Securities sold under repurchase agreements - The fair values of securities sold under repurchase agreements are equal to the carrying value due to the short-term nature of these instruments.

Borrowed Money - The fair values for borrowed money are estimated based on discounted future cash flows using current discount rates for similar borrowings.

Subordinated debt - The fair values for subordinated debt are estimated based on a broker indication of fair value at the respective dates.

At March 31, 2012 and December 31, 2011, the Company had outstanding unfunded commitments to extend credit offered in the normal course of business.  Fair values of these commitments are based on fees currently charged for similar instruments.  At March 31, 2012 and December 31, 2011, the carrying amounts and fair values of these off-balance sheet financial instruments were considered immaterial.

28

The carrying amounts and estimated fair valuesof financial instruments at the respective dates were as follows:

	March 31, 2012				December 31, 2011
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
	(Dollars in thousands)
Financial assets:
Cash and noninterest-bearing deposits	$	12,724	$	12,724	$	13,296	$	13,296
Interest-earning bank balances		102,698		102,698		75,048		75,048
Investment securities		121,411		123,173		147,899		150,251
Federal Home Loan Bank stock		5,067		5,067		5,067		5,067
Presold loans in process of settlement		4,666		4,666		2,146		2,146
Loans receivable, net		716,942		731,783		722,075		735,685
FDIC loss share receivable		30,448		30,448		38,931		38,931
Accrued interest receivable		2,577		2,577		2,773		2,773
Bank-owned life insurance		18,554		18,554		18,978		18,978
Financial liabilities:
Demand deposits	$	298,112	$	298,112	$	287,466	$	287,466
Money market accounts		155,599		155,599		155,229		155,229
Savings accounts		22,147		22,147		20,542		20,542
Time deposits		396,788		399,009		412,819		415,145
Securities sold under repurchase agreements		9,919		9,919		9,787		9,787
Borrowed money		78,697		86,795		78,688		87,697
Subordinated debt		15,464		7,732		15,464		7,732
Accrued interest payable		843		843		981		981

Note 14 – Subsequent Events

The Company has evaluated subsequent events for accounting and disclosure purposes through the date the financial statements are issued.

Merger with Park Sterling Corporation. On May 14, 2012, the Company announced the signing of a definitive merger agreement with Park Sterling Corporation (“Park Sterling”) under which Park Sterling will acquire Citizens South for a total value of approximately $77.8 million, excluding the exchange of $20.5 million in preferred stock issued to the United States Department of the Treasury in connection with Citizens South's participation in the Small Business Lending Fund. The merger agreement has been unanimously approved by the board of directors of each company. Closing of the transaction, which is expected to occur in the fourth quarter of 2012, is subject to customary conditions, including approval by Citizens South's shareholders, approval by Park Sterling's shareholders and receipt of regulatory approval. Under the terms of the merger agreement, Citizens South shareholders will have the right to receive either $7.00 in cash or 1.4799 Park Sterling shares for each Citizens South share they hold, subject to the limitation that the total consideration will consist of 30.0% in cash and 70.0% in Park Sterling shares. Those Citizens South shares exchanged for stock will convert to Park Sterling shares in what is intended to be a tax-free exchange. Cash will also be paid in lieu of fractional shares. The transaction value at the time of the proposed merger may change due to potential fluctuations in the price of Park Sterling stock.

Dividend Declaration.  On April 23, 2012, the Board of Directors of the Company approved and declared a regular cash dividend of one cent ($0.01) per share of common stock to shareholders of record as of May 4, 2012, payable on May 18, 2012. The Company has paid cash dividends in each of the 56 quarters since the Company’s conversion to public ownership.

29

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

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the Company’s financial condition, results of operations and business of the Company and the Bank.  These statements are based on assumptions and estimates 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.  Such forward- looking statements can be identified by the use of words such as  “may,” “would,” “could,” “will,” “expect,” “believe,” “estimate,” “intend,” and “plan,” as well as similar expressions. Such 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.  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, 1) the timing and amount of revenues that may be recognized by the Company, 2) changes in local or national economic trends, 3) increased competition among depository and financial institutions, 4) continuation of current revenue and expense trends (including trends affecting charge-offs and provisions for loan losses), 5) changes in interest rates and the shape of the yield curve, 6) our ability to continue to expand our small business lending and thereby reduce the dividend rate on our SBLF preferred stock, and 7) adverse legal, regulatory or accounting changes and other risk factors described under Item 1A. “Risk Factors” of the Company’s 2011 Annual Report on Form 10-K and other filings made with the Securities and Exchange Commission.  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.

Non-GAAP Financial Measures

This quarterly report contains certain non-GAAP financial measures and should be read along with the accompanying tables which provide a reconciliation of non-GAAP measures to GAAP measures.  Management believes that these non-GAAP measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods.  Non-GAAP measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under accounting principles generally accepted in the United States (“GAAP”), and investors should consider the company’s performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the company.   Non-GAAP measures have limitations as analytical tools, and investors should not consider them in isolation, or as a substitute for analysis of the Company’s results or financial condition as reported under GAAP.

Executive Summary

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"). The shares of common stock of the Company trade on the Nasdaq Global Market under the ticker symbol “CSBC.”  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 Company became the holding company for the Bank on September 30, 2002, in connection with the mutual-to-stock conversion of Citizens South Holdings, MHC, the mutual holding company of Citizens South Banking Corporation, a federal corporation, formerly named Gaston Federal Bancorp, Inc., which was originally formed on March 18, 1998, for the purpose of acting as the holding company for the Bank.

Citizens South Bank was chartered in 1904 and currently operates as a federally chartered savings bank. The Bank is headquartered in Gastonia, North Carolina, which is located approximately 20 miles west of Charlotte, North Carolina.  The Bank’s executive office is located at 519 South New Hope Road, P.O. Box 2249, Gastonia, North Carolina 28053-2249 and its telephone number is (704) 868-5200. The Company also maintains a website at www.citizenssouth.com that includes important information on our Bank, including a list of our products and services, branch locations and current financial information.  Information on our website should not be considered a part of this interim report.

30

The Bank provides a full range of retail products, commercial banking services, and mortgage lending services to local customers through our 21 branch offices located in North Carolina, South Carolina, and Georgia.  Our primary banking activities include the acceptance of deposits and the origination of loans.  We offer retail deposit products such as checking, savings, and money market accounts, as well as time deposits and individual retirement accounts.  For business customers, the Bank offers commercial analysis deposit accounts, business checking accounts, and repurchase agreements (also called securities sold under agreement to repurchase).  The Bank is a member of the Certificate of Deposit Account Registry Service (“CDARS”), which gives our customers the ability to obtain FDIC insurance on deposits of up to $50 million, while continuing to work directly with our Bank. The Bank also offers a wide variety of consumer and commercial loans including business loans, real estate loans, residential loans and consumer loans.  We offer consumer and business credit cards, debit cards, commercial letters of credit, safe deposit box rentals, and electronic funds transfer services, including automated clearing house, or ACH, and wire transfers.  In addition, the Bank offers online banking, remote deposit capture, cash management, bank-by-phone capabilities, and ATM services.   The Bank also acts as a broker in the sale of uninsured financial products.

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-month periods ended March 31, 2012 and 2011.  Financial highlights for the five previous quarters are presented in the following tables.

31

Quarterly Financial Highlights (unaudited)	At and For the Quarters Ended
	2012			2011
	March 31			December 31			September 30			June 30			March 31
(Dollars in thousands, except share and per share data)
Summary of Operations:
Interest income - taxable equivalent	$	10,528		$	11,089		$	11,308		$	11,488		$	10,457
Interest expense		2,016			2,304			2,554			2,826			2,855
Net interest income - taxable equivalent		8,512			8,785			8,754			8,662			7,602
Less: Taxable-equivalent adjustment		59			65			62			69			70
Net interest income		8,453			8,720			8,692			8,593			7,532
Provision for loan losses		6,300			4,635			1,350			1,700			3,000
Net interest income after loan loss provision		2,153			4,085			7,342			6,893			4,532
Noninterest income		2,719			1,985			1,990			5,886			1,478
Noninterest expense		8,684			8,779			8,931			9,270			7,672
Net income (loss) before income taxes		(3,812	)		(2,709	)		401			3,509			(1,662	)
Income tax expense (benefit)		(1,672	)		(1,172	)		28			1,213			(771	)
Net income (loss)		(2,140	)		(1,537	)		373			2,296			(891	)
Dividends and accretion of discount on preferred stock		122			767			247			256			256
Net income (loss) available to common shareholders	$	(2,262	)	$	(2,304	)	$	126		$	2,040		$	(1,147	)
Per Common Share Data:
Net income (loss):
Basic	$	(0.20	)	$	(0.20	)	$	0.01		$	0.18		$	(0.10	)
Diluted		(0.20	)		(0.20	)		0.01			0.18			(0.10	)
Weighted average shares outstanding:
Basic		11,469,525			11,470,599			11,462,107			11,455,642			11,454,919
Diluted		11,469,525			11,470,599			11,462,107			11,455,642			11,454,919
End of period shares outstanding		11,506,324			11,506,324			11,506,324			11,506,324			11,508,750
Cash dividends declared	$	0.01		$	0.01		$	0.01		$	0.01		$	0.01
Book value		6.04			6.27			6.44			6.44			6.22
Tangible book value		5.93			6.15			6.31			6.29			6.09
Selected Financial Performance Ratios (annualized):
Return on average assets		(0.85	)%		(0.85	)%		0.05	%		0.73	%		(0.44	)%
Return on average common equity		(12.86	)%		(12.45	)%		0.68	%		11.00	%		(6.39	)%
Noninterest income to average total assets		1.02	%		0.73	%		0.72	%		2.12	%		0.56	%
Noninterest expense to average total assets		3.25	%		3.24	%		3.23	%		3.34	%		2.91	%
Efficiency ratio		77.73	%		82.01	%		83.61	%		64.02	%		85.15	%
Operating Earnings (Non-GAAP):
Net income (loss) available to common shareholders	$	(2,262	)	$	(2,304	)	$	126		$	2,040		$	(1,147	)
(Gain) loss on acquisition, net of tax		-			(15	)		29			(2,695	)		155
Gain on sale of investments, net of tax		(405	)		-			(67	)		-			-
Other-than-temporary impairment on securities, net of tax		-			22			-			-			-
Acquisition and integration expenses, net of tax		-			584			86			345			27
Net operating income (loss)	$	(2,667	)	$	(1,713	)	$	174		$	(310	)	$	(965	)
Operating net income (loss) per common share:
Basic	$	(0.23	)	$	(0.15	)	$	0.02		$	(0.03	)	$	(0.08	)
Diluted		(0.23	)		(0.15	)		0.02			(0.03	)		(0.08	)
Pre-tax, pre-credit earnings  (1)	$	3,543		$	3,545		$	3,545		$	3,902		$	2,638
Operating return on average assets		(1.00	)%		(0.63	)%		0.06	%		(0.11	)%		(0.37	)%
Operating return on average equity		(11.72	)%		(7.29	)%		0.73	%		(1.30	)%		(4.13	)%
Operating efficiency ratio  (2)		68.13	%		69.52	%		67.52	%		65.92	%		72.99	%

(1)	Calculated using net interest income plus noninterest income less noninterest expense adjusted for the following items: 1) gains or losses from acquisition or sale of investments or sale of other assets; 2) other-than-temporary impairment on securities; 3) amortization of intangible assets; 4) other real estate owned valuation adjustments and expenses; and 5) acquisition and integration expenses.
(2)	Calculated by dividing noninterest expense by net interest income plus noninterest income excluding the following items: 1) gains or losses from acquisition or sale of investments; 2) other-than-temporary impairment on securities; 3) other real estate owned valuation adjustments and expenses; and 4) acquisition and integration expenses.

32

Quarterly Financial Highlights (unaudited)	At and For the Quarters Ended
	2012			2011
	March 31			December 31			September 30			June 30			March 31
(Dollars in thousands, except per share data)
Credit Quality Information and Ratios:
Allowance for loan losses - beginning of period	$	11,713		$	12,956		$	12,742		$	12,006		$	11,924
Add:  Provision for loan losses		6,300			4,635			1,350			1,700			3,000
Less:  Net charge-offs		6,430			5,878			1,136			964			2,918
Allowance for loan losses - end of period	$	11,583		$	11,713		$	12,956		$	12,742		$	12,006
Assets not covered by FDIC loss-share agreements:
Past due loans (30-89 days) accruing	$	5,362		$	4,933		$	4,479		$	5,687		$	5,692
Past due loans (30-89 days) to total non-covered loans		0.92	%		0.86	%		0.77	%		0.99	%		0.97	%
Nonperforming non-covered loans:
One-to-four family residential	$	2,698		$	2,407		$	1,556		$	1,406		$	2,373
Construction		-			-			-			-			72
Commercial land		3,852			2,631			3,176			3,167			4,653
Residential development		3,742			6,474			6,459			5,155			4,675
Other commercial real estate		8,924			4,173			6,602			10,306			9,636
Commercial business		1,086			168			306			201			309
Consumer		1,750			2,958			2,426			2,440			2,639
Total nonperforming non-covered loans		22,052			18,811			20,525			22,675			24,357
Other nonperforming non-covered assets		11,987			8,936			8,208			10,723			8,463
Total nonperforming non-covered assets	$	34,039		$	27,747		$	28,733		$	33,398		$	32,820
Allowance for loan losses to total non-covered loans		2.00	%		2.04	%		2.23	%		2.22	%		2.05	%
Net charge-offs to average non-covered loans (annualized)		4.44	%		4.07	%		0.79	%		0.66	%		2.00	%
Nonperforming non-covered loans to non-covered loans		3.80	%		3.28	%		3.53	%		3.95	%		4.15	%
Nonperforming non-covered assets to total assets		3.17	%		2.57	%		2.61	%		2.99	%		3.15	%
Nonperforming non-covered assets to total non-covered loans and other real estate owned		5.75	%		4.76	%		4.87	%		5.72	%		5.51	%
Assets covered by FDIC loss-share agreements:
Past due loans (30-89 days) accruing (3)	$	2,726		$	5,372		$	6,430		$	12,987		$	7,006
Past due loans (30-89 days) to total covered loans		1.83	%		3.36	%		3.81	%		7.34	%		5.09	%
Total covered nonperforming loans (4)	$	40,582		$	44,056		$	37,074		$	35,830		$	24,791
Other covered nonperforming assets		9,447			8,746			12,765			14,127			8,225
Total covered nonperforming assets	$	50,029		$	52,802		$	49,839		$	49,957		$	33,016
Classified Assets(5)
Non-covered classified loans	$	32,147		$	28,727		$	35,357		$	41,515		$	42,915
OREO and other nonperforming assets		11,987			8,936			8,208			10,723			8,463
Total classified assets	$	44,134		$	37,663		$	43,565		$	52,238		$	51,378
Tier 1 capital	$	100,774		$	102,539		$	104,487		$	105,088		$	102,628
Total classified assets to Tier 1 capital		43.80	%		36.73	%		41.69	%		49.71	%		50.06	%

(3)	The contractual balance of past due loans covered by  FDIC loss-share agreements totaled $7.7 million $13.7 million, $8.2 million, $7.0 million and $3.5 million at December 31, 2010, March 31, 2011, June 30, 2011, September 30, 2011, December 31, 2011 and March 31, 2012 respectively.
(4)	The contractual balance of nonperforming loans covered by  FDIC loss-share agreements totaled $31.2 million, $28.7 million $39.3 million $48.8 million, $55.4 million and $46.2 million at December 31, 2010, March 31, 2011, June 30, 2011, September 30, 2011, December 31, 2011, and March 31, 2012 respectively.
(5)	Excludes loans and OREO covered by FDIC loss-share agreements.

33

Quarterly Financial Highlights (unaudited)	At and For the Quarters Ended
	2012			2011
	March 31			December 31			September 30			June 30			March 31
(Dollars in thousands, except per share data)
Net Interest Margin (annualized):
Yield on earning assets		4.75	%		4.81	%		4.84	%		4.95	%		4.62	%
Cost of funds		0.92	%		1.01	%		1.11	%		1.23	%		1.32	%
Net interest rate spread		3.83	%		3.80	%		3.73	%		3.72	%		3.30	%
Net interest margin (taxable equivalent)		3.88	%		3.84	%		3.76	%		3.78	%		3.42	%
Selected End of Period Balances:
Loans covered by FDIC loss-share agreements	$	148,833		$	159,688		$	168,940		$	177,047		$	137,758
Loans not covered by FDIC loss-share agreements		579,692			574,100			582,065			573,603			586,897
Total loans, net		728,525			733,788			751,005			750,650			724,655
Investment securities		121,411			147,899			132,443			156,328			154,006
Total interest-earning assets		890,456			895,003			913,910			927,463			887,706
Total assets		1,073,815			1,080,460			1,098,974			1,117,993			1,041,444
Noninterest-bearing deposits		97,437			88,077			87,413			82,305			78,342
Interest-bearing deposits		775,209			787,979			801,167			822,273			754,461
Total deposits		872,646			876,056			888,580			904,578			832,803
Total borrowings and other debt		104,080			103,939			105,778			108,011			107,646
Shareholders' equity		90,010			92,659			94,782			94,771			92,276
Selected Quarterly Average Balances:
Loans covered by FDIC loss-share agreements	$	154,344		$	164,314		$	173,755		$	170,580		$	142,353
Loans not covered by FDIC loss-share agreements		579,224			578,083			576,846			583,294			583,993
Average loans, net		733,568			742,397			750,601			753,874			726,346
Investment securities		128,086			140,846			146,017			157,513			135,645
Average interest-earning assets		880,073			906,064			920,932			918,118			902,141
Average total assets		1,069,651			1,084,313			1,107,687			1,110,740			1,053,747
Noninterest-bearing deposits		90,024			87,770			84,001			81,617			72,235
Interest-bearing deposits		777,621			789,233			810,469			814,736			769,152
Average total deposits		867,645			877,003			894,470			896,353			841,387
Average borrowings and other debt		103,181			105,872			106,696			107,872			109,385
Shareholders' equity		91,057			94,028			94,711			95,116			93,533
Capital Ratios:
Total equity to total assets		8.38	%		8.58	%		8.62	%		8.48	%		8.86	%
Tangible common equity to tangible assets		6.36	%		6.56	%		6.61	%		6.49	%		6.73	%
Total Risk-Based Capital (Bank only)		15.50	%		15.60	%		17.32	%		17.29	%		16.70	%
Tier 1 Risk-Based Capital (Bank only)		14.25	%		14.35	%		16.06	%		16.03	%		15.44	%
Tier 1 Leverage Capital (Bank only)		9.42	%		9.44	%		9.53	%		9.42	%		9.89	%

34

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 (“GAAP”) and conform to general practices in the banking industry.  We consider accounting policies that require difficult or subjective 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 Company’s portfolio at the measurement date.  Management’s determination of the adequacy of the allowance is based on periodic 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 consistently applied, 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.  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.  Specific allowances or principal write-downs 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.  We increase our allowance for loan losses by charging provisions for loan losses against our current period income.  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 (“OTTI”).The Company reviews all investment securities with significant declines in fair value for potential OTTI on at least a quarterly basis. Consideration is given to the amount of time that the impairment has existed, the financial condition of the issuer and the probability of receiving the required payments on the investments.  Also, the Company’s intent and ability to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value or for a debt security whether it is more-likely-than-not that the Company will be required to sell the debt security prior to recovering its fair value is considered.  The Company records an impairment charge when it believes an investment has experienced a decline in value that is OTTI.  Generally changes in market interest rates that result in a decline in value of an investment security are considered to be temporary, since the value of such investment can recover in the foreseeable future as market interest rates return to their original levels.  Management believes this is a critical accounting policy because this evaluation of the underlying credit or analysis of other conditions contributing to the decline in value involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters.

Fair Value of Acquired Loans.The initial fair value of loans acquired in FDIC-assisted acquisitions and the related FDIC loss-share receivable involved a high degree of judgment and complexity.  On March 19, 2010, the Bank acquired Bank of Hiawassee in an FDIC-assisted acquisition and on April 15, 2011, the Bank acquired New Horizons Bank in an FDIC-assisted transaction.  The carrying value of the acquired loans and the FDIC loss-share receivable reflect management’s best estimate based on information available at the time of the acquisition.  The amount that the Bank actually receives on these loans could differ materially from the carrying value reflected in the financial statements based upon the timing and collections on the acquired loans in the future.  To the extent that actual values realized for the acquired loans are different from the initial estimates, the FDIC loss-share receivable will generally be impacted in an offsetting manner due to the nature of the FDIC loss-share agreements.

35

Comparison of Financial Condition for the Periods Ended March 31, 2012 and December 31, 2011

Assets.  During the first quarter of 2012 total assets of the Company decreased by $6.6 million, or 0.6%, to $1.1 billion at March 31, 2012, as detailed in the following paragraphs.

Total cash and cash equivalents, which include cash and due from banks and interest bearing deposits, increased by $27.1 million, or 30.7%, from $88.3 million at December 31, 2011, to $115.4 million at March 31, 2012. This increase in cash and cash equivalents was primarily attributable to the sale of $35.5 million of investment securities.  The Company’s excess liquidity was held in the Bank’s account with the Federal Reserve Bank.  Management expects that a portion of these low-yielding bank deposits will be invested in higher-yielding loans and investments over the next several quarters.

During the three-month period ended March 31, 2012, loans receivable decreased by $5.3 million, or 0.7%, to $728.5 million at March 31, 2012.  This decrease was primarily due to the Company’s continuing efforts to reduce exposures in its commercial land and residential development loans, coupled with reduced loan demand. During the three-month period ended March 31, 2012, the Company’s non-covered commercial land and residential development loans decreased by $9.0 million, or 20.1%, to $35.6 million.  The Company remains focused on originating owner-occupied commercial real estate loans, commercial business loans, residential loans, and consumer loans to qualified borrowers.

A majority of the Company’s loans are to borrowers that are located in the Charlotte region.  While the economy in the Charlotte region has generally outperformed most other large metropolitan areas of the country during the ongoing economic slowdown, the economy in the Charlotte region remains sluggish.  However, the Company’s loan production has improved from $29.4 million during the first three months of 2011 to $40.2 million during the first three months of 2012.  The Company’s expansion into the North Georgia market will allow the Company to geographically diversify its loan portfolio.  Although the North Georgia market has sustained significant decreases in real estate values over the past several years, management believes that when economic conditions normalize, this new market will be able to provide additional loan growth for the Company. While continued economic slowdowns in the local markets that we serve would have a negative impact on the Company’s ability to generate loan growth, management will seek to grow the loan portfolio in a prudent manner with an emphasis on borrowers that have a demonstrated capacity to meet their debt obligations, even in the current economic environment.

During the three-month period ended March 31, 2012, investment securities decreased by $26.5 million, or 17.9%, to $121.4 million.  The decrease was due to the sale of $35.5 million in investment securities, the effects of which were partly offset by the purchase of $21.3 million of investment securities.  These purchased securities were primarily U.S. Government agency amortizing securities that provide for periodic cash flow that can be reinvested in higher-yielding loans when loan demand strengthens and U.S. Government Agency bonds. The investments that were sold included similar types of securities.  Management expects the investment portfolio to increase as a percentage of total assets over the next 12 months as a portion of the Company’s excess liquidity is invested in higher-yielding investments.

Other real estate owned, which includes all properties acquired by the Company through foreclosure, totaled $21.3 million at March 31, 2012, compared to $17.6 million at December 31, 2011.   Of the $21.3 million in other real estate owned at March 31, 2012, $9.4 million is covered by FDIC loss-share agreements.  The remaining $11.9 million of non-covered other real estate owned is comprised of $1.8 million of one-to-four family residential dwellings, $6.0 million of undeveloped land, $3.8 million of developed residential lots, and $464,000 of commercial real estate.  All foreclosed properties are written down to their estimated fair value (market value less estimated disposition costs) at acquisition and are predominately located in the Bank’s primary lending area.  Properties may be reappraised after acquisition as market conditions change, resulting in additional valuation adjustments which are reflected in current period noninterest expenses.  Management will continue to aggressively market foreclosed properties for a timely disposition.

36

During the first three months of 2012, premises and equipment decreased by $217,000, or 0.8%, to $25.7 million at March 31, 2012.  This decrease was primarily due to normal depreciation which totaled $327,000 during the first three months of 2012.

During the first quarter of 2012, the Company’s FDIC loss share receivable decreased from $38.9 million at December 31, 2011, to $30.4 million at March 31, 2012.  This $8.4 million decrease was primarily due to the $9.9 million reimbursement payment that was made by the FDIC to the Bank during the quarter. These reimbursement payments are based on certificates filed by the Bank with the FDIC on a quarterly basis detailing charge-offs and other qualified expenses on covered loans.

Liabilities. Total liabilities decreased by $4.0 million, or 0.4%, from $987.8 million at December 31, 2011, to $983.8 million at March 31, 2012, as detailed in the following paragraphs.

During the first three months of 2012, total deposits decreased by $3.4 million, or 0.4%, to $872.6 million at March 31, 2012. The decrease in deposits was primarily due to a $16.0 million, or 3.9%, decline in time deposits. This decrease in time deposits was primarily due to the Company’s continued focus on building customer banking relationships and avoiding growth through offering above market rates on time deposits.  Excluding the time deposits, total core deposits increased by $12.6 million, or 2.7%, to $475.9 million at March 31, 2012.  This core deposit growth included a $9.4 million, or 10.6%, increase in non-interest bearing demand deposits, a $1.3 million, or 0.6%, increase in interest-bearing demand deposit accounts, a $371,000, or 0.2%, increase in money market accounts, and a $1.6 million, or 7.8%, increase in savings accounts.   We believe our core deposit growth was partly due to a flight to safety as funds moved from weaker financial institutions as well as a continued emphasis on increasing the Company’s retail and business customers through cross-selling opportunities.

During the first three months of 2012 borrowed money remained relatively flat at $78.7 million at March 31, 2012. The Company plans to use excess liquidity to repay these borrowings as they mature.  From time to time additional borrowed money may be used to fund additional loan growth, or to purchase investment securities.

Shareholders’ Equity.  Total shareholders’ equity decreased by $2.6 million, or 2.9%, from $92.7 million at December 31, 2011, to $90.0 million at March 31, 2012.  This decrease was primarily due to the net loss of $2.1 million during the three-month period and the $325,000 of other comprehensive loss that was due to the decrease in the fair value of investment securities, available for sale, during the three-month period ended March 31, 2012.  In addition, during the first quarter of 2012 the Company paid $115,000 in cash dividends on common stock and $122,000 in cash dividends on preferred stock, which also reduced shareholders’ equity.

Comparison of Results of Operations for the Three Months Ended March 31, 2012 and 2011

General.  Net loss allocable to common shareholders for the three months ended March 31, 2012, amounted to $2.3 million, or $0.20 per diluted share, as compared to a net loss allocable to common shareholders of $1.2 million, or $0.10 per diluted share, for the three months ended March 31, 2011.

Net interest income. Net interest income increased by $921,000, or 12.2%, to $8.5 million for the first quarter of 2012 as compared to $7.5 million for the first quarter of 2011. The Company’s net interest margin increased by 46 basis points to 3.88% for the quarter ended March 31, 2012, compared to 3.42% for the quarter ended March 31, 2011.  This increase in the net interest margin was the result of a 40 basis point decrease in the cost of funds and a 13 basis point increase in the yield on assets.

Interest income increased by $82,000, or 0.8%, to $10.5 million for the first quarter of 2012.  This increase was primarily due to a 13 basis points increase in the Company’s yield on assets from 4.62% for the quarter ended March 31, 2011, to 4.75% for the quarter ended March 31, 2012.  The increase in the yield on assets was partially offset by a $22.1 million, or 2.4%, decrease in average interest-earning assets during the comparable first quarter periods to $880.1 million for the quarter ending March 31, 2012.  During the comparable first quarter periods, average interest-earning deposits decreased by $3.4 million, or 4.0%, to $83.3 million for the first quarter of 2012, average investment securities decreased by $7.6 million, or 5.6%, to $128.1 million for the first quarter of 2012, and average accruing loans decreased by $11.1 million, or 1.6%, to $668.7 million for the first quarter of 2012.  Average accruing loans decreased due to higher levels of repayments resulting from lower market interest rates and higher levels of average nonaccrual loans during the comparable periods.

37

Interest expense decreased by $839,000, or 29.4%, for the comparable quarters to $2.0 million for the first quarter of 2012.  This decrease in interest expense was largely due to lower market interest rates, which resulted in a 40 basis point decrease in the average cost of funds to 0.92% for the quarter ended March 31, 2012.  Partially offsetting the positive effects of the lower cost of funds was a $2.3 million, or 0.3%, increase in the average interest-bearing liabilities to $880.8 million for the first quarter of 2012.  This change included an $8.5 million, or 1.1%, increase in average interest-bearing deposits and a $6.2 million, or 5.7%, decrease in average borrowings.  The increase in average interest-bearing deposits was largely due to the acquisition of New Horizons Bank, while the decrease in average borrowings was due to normal maturities during the period.

Provision for loan losses.  The Company’s provision for loan losses increased from $3.0 million for the first quarter of 2011 to $6.3 million for the first quarter of 2012.  The increase in the provision for loan losses was largely due to the higher level of net charge-offs which totaled $6.4 million, or 4.4% of average non-covered loans annualized, during the first quarter of 2012 compared to $2.9 million, or 2.0% of average non-covered loans annualized, during the first quarter of 2011.  The Company’s ratio of nonperforming non-covered assets to total assets increased slightly to 3.17% at March 31, 2012, compared to 3.15% at March 31, 2011.  Management expects that the Company’s provision for loan losses during the next several quarters will be more in line with the amount incurred during the first quarter of 2011 rather than the amount incurred during the first quarter of 2012.

Noninterest income.  Noninterest income increased by $1.2 million to $2.7 million for the three months ended March 31, 2012, as compared to $1.5 million for the three months ended March 31, 2011. The primary reason for the increase was a $255,000 decrease in the loss from acquisition, a $664,000 increase in the gain on sale of investments and a $362,000 increase in other noninterest income.  These increases were partly offset by a $150,000 increase in the loss on sale of other assets.  The following table presents the detail for the three-month periods ending March 31, 2012 and March 31, 2011.

	Three Months Ended
	March 31
	2012			2011			Variance
	(Dollars in thousands)
Noninterest income:
Service charges on deposit accounts	$	1,055		$	957		$	98
Mortgage banking income		317			237			80
Commissions on sales of financial products		86			67			19
Income from bank-owned life insurance		184			182			2
Loss from acquisition		-			(255	)		255
Gain on sale of investments, available for sale		664			-			664
Gain (loss) on sale of other assets		(138	)		12			(150	)
Other		551			278			273
Total noninterest income	$	2,719		$	1,478		$	1,241

Service charges on deposit accounts were higher due to the increased number of demand deposit accounts, due in part to the acquisition of New Horizons Bank in April 2011, which generate monthly service charges and non-sufficient fund fees on overdrafts.  Mortgage banking income was higher in the first quarter of 2012 due to increased origination activity resulting largely from lower mortgage loan interest rates.  Commissions on sales of financial products were slightly higher in 2012 due to increased transactions during the period.  Income from bank-owned life insurance was flat during the respective quarters. The loss from acquisition in the first quarter of 2011 was an adjustment to the initial $18.7 million gain that was booked in conjunction with the acquisition of Bank of Hiawassee. The gain on sale of investments was higher during the first quarter of 2012, due to the fact that there were no investments sold during the first quarter of 2011.  The loss on sale of other assets was higher due to the recognition of gains from the sale of other real estate owned during the first quarter of 2011.  Other income increased primarily due the receipt of life insurance proceeds relating to the death of a former director.

38

Noninterest expense. Noninterest expense increased by $1.0 million, or 13.0%, to $8.8 million for the quarter ended March 31, 2012.  The following table presents the detail of noninterest expense for the three-month periods ending March 31, 2012 and March 31, 2011.

	Three Months Ended
	March 31
	2012		2011		Variance
	(Dollars in thousands)
Noninterest Expense:
Compensation and benefits	$	3,846	$	3,648	$	198
Occupancy and equipment		908		828		80
Data processing and other technology		255		183		72
Professional services		275		253		22
Advertising and business development		68		54		14
Loan collection and other expenses		251		290		(39	)
Deposit insurance		418		334		84
Amortization of intangible assets		122		139		(17	)
Office supplies		60		70		(10	)
Telephone and communications		106		97		9
Other real estate owned valuation adjustments		1,000		509		491
Other real estate owned expenses		469		364		105
Acquisition and integration expenses		-		45		(45	)
Other		906		858		48
Total noninterest expense	$	8,684	$	7,672	$	1,012

Compensation and benefits increased due to the employees that were added as a part of the New Horizons Bank acquisition in April 2011.  Occupancy and equipment expense increased in part due to the addition of one full service office as a result of the aforementioned acquisition. Increases in data processing and other technology, advertising and business development and deposit insurance were also largely related to the new market and the additional accounts and customers that resulted from the New Horizons Bank acquisition.  Professional services increased due to higher consulting fees incurred during the first quarter of 2012 as compared to the first quarter of 2011.  Loan collection and other expenses decreased due to lower FDIC-covered expenses during the first quarter of 2012 compared to the first quarter of 2011.  Amortization of intangible assets was slightly lower due to the reduced amortization expense related to the core deposit intangible that was created as a result of previous acquisitions.  This intangible asset is being amortized over an eight-year period using the accelerated method, resulting in a progressive decreased expense over the amortization period.  Office supplies and telephone and communications expenses were relatively unchanged during the respective quarters.  Other real estate owned valuation adjustments and other real estate owned expenses increased due to a higher number of foreclosed properties and a decline in local real estate values for commercial land and residential development properties during the past year.  Acquisition and integration expenses decreased since there were no acquisition or integration-related expenses during the first quarter of 2012. Other expenses increased primarily as a result of higher stock-related expenses, insurance premiums, postage and other various miscellaneous items.

Income taxes. The Company recognized an income tax benefit of $1.7 million for the quarter ended March 31, 2012, compared to an income tax benefit of $771,000 for the quarter ended March 31, 2011.  The increase in the income tax benefit was due to the decrease in the pre-tax income in the first quarter of 2012 compared to the pre-tax loss in the first quarter of 2011.

39

Liquidity

The objectives of the Company’s liquidity management policy include providing adequate funds to meet the cash needs of both borrowers and depositors, to provide for the on-going operations of the Company, and to capitalize on opportunities for expansion.  Liquidity management addresses the Company’s ability to meet deposit withdrawals on demand or at contractual maturity, to repay borrowings as they mature, and to fund new loans and investments as opportunities arise.  The primary sources of internally generated funds are principal and interest payments on loans receivable, increases in local deposits, cash flows generated from operations, and cash flows generated by investments.  As of March 31, 2012, the Company’s cash and cash equivalents totaled $115.4 million.  Of this amount, $102.5 million was held in the Company’s account with the Federal Reserve Bank.  If the Company requires funds beyond its internal funding capabilities, it may rely upon external sources of funds such as brokered deposits, repurchase agreements, and advances.  The Company has $104.4 million available to draw from its line of credit with the FHLB.  The FHLB functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB, we are required to own capital stock in the FHLB and we are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally investment securities that are obligations of, or guaranteed by, U.S. Government Agencies, or Government Sponsored Enterprises) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit.  The Company also has $16.0 million available from an unsecured federal funds accommodation with Pacific Coast Bankers Bank (“PCBB”).  PCBB is the Company’s primary correspondent bank. The federal funds facility is available through September 30, 2012, and is used for the purpose of providing daily liquidity as needed by the Company.  Outstanding advances made under this facility are generally repaid on a daily basis at a rate determined by PCBB based on their marginal cost of funds.  Advances are limited to not more than 10 consecutive days at a time.  The Company also has an unsecured federal funds accommodation with CenterState Bank of Florida in the amount of $5.0 million.  The credit facility, which is used to fund short-term liquidity needs, may be terminated at any time and may not be outstanding for more than 14 consecutive days.   The Company may also solicit brokered deposits for providing funds for asset growth.  As of March 31, 2012, the Company had no outstanding brokered deposits and $443,000 of internet deposits that were assumed from the acquisition of New Horizons Bank.  These internet deposits are not renewed at maturity. The Company believes that it has sufficient sources of liquidity to fund the cash needs of both borrowers and depositors, to provide for the ongoing operations of the Company, and to capitalize on opportunities for expansion.

In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements.  Commitments to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  The funding of these commitments and previously approved undisbursed lines of credit could affect the Company's liquidity position.  At March 31, 2012, the Company had loan commitments of $13.1 million, unused lines of credit of $112.3 million, and undisbursed construction loan proceeds of $795,000.  The Company also has various leases in place to provide office space for four full-service offices and one in-store office.  The current annualized cost of these leases was $641,000.  Two leases totaling approximately $175,000 expire in 2012 and are not expected to be renewed.  Short-term borrowings totaled $25.1 million at March 31, 2012.  These short-term borrowings consisted of $9.9 million of daily securities sold under repurchase agreements and $15.2 million of FHLB advances that mature over the next 12 months. The Company does not have any special purpose entities or other similar forms of off-balance-sheet financing. The Company believes that given its current level of internal and external sources of liquidity, it has adequate resources to fund loan commitments and lines of credit, repay short-term borrowings if necessary, and fund any other normal obligations that may arise in the near future.

40

Capital Resources

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

The Bank’s actual capital levels and regulatory capital ratios as of March 31, 2012, are presented in the following table.

						Minimum Requirements to
	Actual					be Well Capitalized
	Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Regulatory Capital Ratios:
Total risk-based capital (to risk-weighted assets)	$	109,650		15.50	%	$	70,739		10.00	%
Tier 1 capital (to risk-weighted assets)		100,774		14.25	%		42,444		6.00	%
Tier 1 capital (to adjusted total assets)		100,774		9.42	%		53,514		5.00	%
Tangible capital (to adjusted total assets)		100,774		9.42	%		32,108		3.00	%

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes to the Company’s asset/liability management strategies or interest rate position that were described in Item 7A. of our Annual Report on Form 10-K for the year ended December 31, 2011.

41

Item 4.  Controls and Procedures

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

As disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2011, during the first quarter of 2012 the Company made the following changes with respect to the Company's internal control over financial reporting:

·  The Company appointed a new Chief Risk Officer.

·  All charge-offs or write downs in excess of $5,000 are now be approved by the Principal Executive Officer.

·  Loan reviews have been completed on all loan relationships of $750,000 or greater, as compared to the prior loan review exposure level of $1,500,000 or greater.

·  A quarterly Classified Loan Asset Report is completed on all troubled relationships of $250,000 or greater, as compared to the prior level of $500,000 or greater.

·  Various additional reports are being prepared and reviewed by the Chief Financial Officer and the Chief Risk Officer to ensure the proper classification of loans as “impaired.”

·  The Bank’s Troubled Asset Officers are managing a larger amount of loans, which, in the past, were handled by lower-level Bank officers.

·  Additional Bank employees are involved in periodic discussions regarding past-due loans and additional discussions are being held relating to various items, including the risk grading, classification and impairment of loans.

·  One employee has been appointed Real Estate Appraisal Assistant to better organize the appraisal process to ensure timely ordering, receipt and review of appraisals.

·  Additional internal system reminders and reviews have been established with respect to the monitoring of certain servicing issues.

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

42

Part II.  Other Information

Item 1. Legal Proceedings

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

Item 1A.  Risk Factors

Not applicable, as the Company is a smaller reporting company.

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

The Company did not repurchase any common stock during the quarter ended March 31, 2012.

Item 6. Exhibits

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

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

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

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

101 Financial statements and related notes formatted in XBRL.

43

SIGNATURES

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

	Citizens South Banking Corporation
Date: May 15, 2012	By:	/s/ Kim S. Price
		Kim S. Price President and Chief Executive Officer
Date: May 15, 2012	By:	/s/ Gary F. Hoskins
		Gary F. Hoskins Executive Vice President, Chief Financial Officer and Treasurer

44