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EX-31 - EXHIBIT 31.2 - CITIZENS SOUTH BANKING CORPexh_312.htm
EX-31 - EXHIBIT 31.1 - CITIZENS SOUTH BANKING CORPexh_311.htm
EX-32 - EXHIBIT 32.1 - CITIZENS SOUTH BANKING CORPexh_321.htm
EX-32 - EXHIBIT 32.2 - CITIZENS SOUTH BANKING CORPexh_322.htm
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, 2011
 
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 [  ]   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 13, 2011, there were 11,508,750 shares outstanding shares of the Registrant’s common stock, $0.01 par value.
 
 

 


 
 

 
Part I. Financial Information
Item 1.  Financial Statements
 
CITIZENS SOUTH BANKING CORPORATION
           
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
       
 
           
             
   
March 31, 2011
   
December 31, 2010
 
(Dollars in thousands, except per share)
 
(unaudited)
   
 
 
             
ASSETS
 
 
   
 
 
Cash and cash equivalents:
           
Cash and due from banks
  $ 10,398     $ 15,110  
Interest-earning bank balances
    57,359       105,789  
Cash and cash equivalents
    67,757       120,899  
Investment securities available for sale, at fair value
    71,117       74,308  
Investment securities held to maturity, at amortized cost
    82,889       37,278  
Federal Home Loan Bank stock, at cost
    5,715       5,715  
Presold loans in process of settlement
    1,255       4,034  
Loans:
               
Covered by FDIC loss-share agreements
    137,758       147,576  
Not covered by FDIC loss-share agreements
    586,897       588,934  
Allowance for loan losses
    (12,006 )     (11,924 )
Net loans
    712,649       724,586  
Other real estate owned
    16,584       14,652  
Premises and equipment, net
    23,587       23,785  
FDIC loss share receivable
    25,611       24,848  
Accrued interest receivable
    2,829       3,001  
Bank-owned life insurance
    18,386       18,230  
Intangible assets
    1,551       1,690  
Other assets
    11,514       11,461  
Total assets
  $ 1,041,444     $ 1,064,487  
 
               
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Deposits
  $ 832,803     $ 850,456  
Securities sold under repurchase agreements
    11,389       9,432  
Borrowed money
    96,257       101,246  
Other liabilities
    8,719       9,910  
Total liabilities
    949,168       971,044  
Commitments and contingencies
               
Shareholders' Equity
               
Preferred stock, $0.01 par value, Authorized: 1,000,000 shares;
               
Issued and outstanding: 20,500 shares
    20,692       20,672  
Common stock, $0.01 par value, Authorized: 20,000,000 shares;
               
Issued: 11,561,464 shares; Outstanding: 11,508,750 shares
    124       124  
Additional paid-in-capital
    63,064       63,000  
Retained earnings, substantially restricted
    8,382       9,663  
Accumulated other comprehensive income (loss)
    14       (16 )
Total shareholders' equity
    92,276       93,443  
Total liabilities and shareholders' equity
  $ 1,041,444     $ 1,064,487  
 
See accompanying notes to consolidated financial statements.
 
1

 
CITIZENS SOUTH BANKING CORPORATION
       
CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
 
             
   
Three Months Ended
 
   
March 31, 2011
   
March 31, 2010
 
(Dollars in thousands, except per share data)
       
             
Interest Income:
           
Interest and fees on loans
  $ 9,461     $ 8,254  
Investment securities:
               
Taxable interest income
    790       617  
Tax-exempt interest income
    69       191  
Other interest income
    67       50  
Total interest income
    10,387       9,112  
Interest Expense:
               
Deposits
    2,002       2,264  
Repurchase agreements
    18       28  
Borrowed money
    835       1,101  
Total interest expense
    2,855       3,393  
                 
Net interest income
    7,532       5,719  
Provision for loan losses
    3,000       3,050  
Net interest income after provision for loan losses
    4,532       2,669  
Noninterest Income:
               
Service charges on deposit accounts
    957       799  
Mortgage banking income
    237       210  
Commissions on sales of financial products
    67       118  
Income from bank-owned life insurance
    182       189  
Gain (loss) from acquisition
    (255 )     18,733  
Gain on sale of investments, available for sale
    -       33  
Gain (loss) on sale of other assets
    12       (62 )
Other income
    278       165  
Total noninterest income
    1,478       20,185  
Noninterest Expense:
               
Compensation and benefits
    3,648       2,643  
Occupancy and equipment
    828       683  
Office supplies
    70       41  
Advertising and business development
    54       57  
Professional services
    253       234  
Telephone and communications
    97       72  
Data processing
    183       140  
Deposit insurance
    334       260  
Amortization of intangible assets
    139       65  
Valuation adjustment on other real estate owned
    509       484  
Acquisition and integration expenses
    45       787  
Other expenses
    1,512       890  
Total noninterest expense
    7,672       6,356  
                 
Income before income tax expense (benefit)
    (1,662 )     16,498  
Income tax expense (benefit)
    (771 )     6,201  
Net income (loss)
    (891 )     10,297  
Dividends on preferred stock
    256       257  
                 
Net income (loss) available to common stockholders
  $ (1,147 )   $ 10,040  
                 
Basic earnings (loss) per common share
  $ (0.10 )   $ 1.29  
Diluted earnings (loss) per common share
    (0.10 )     1.29  

See accompanying notes to consolidated financial statements.
 
2

 
CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (unaudited)
 
                     
Retained
   
Accumulated
       
               
Additional
   
Earnings
   
Other
   
Total
 
   
Preferred
   
Common
   
Paid-in
   
Substantially
   
Comprehensive
   
Shareholders'
 
   
Stock
   
Stock
   
Capital
   
Restricted
   
Income (Loss)
   
Equity
 
(Dollars in thousands)
                                   
                                     
Balances, January 1, 2010
  $ 20,589     $ 91     $ 48,528     $ 3,411     $ (297 )   $ 72,322  
                                                 
Comprehensive results:
                                               
Net income
    -       -       -       10,297       -       10,297  
Other comprehensive results, net of tax
    -       -       -       -       128       128  
Issuance of common stock
    -       15       5,745       -       -       5,760  
Issuance of preferred stock
    8,280       -       -       -       -       8,280  
Accretion of discount on preferred stock
    21       -       -       (21 )     -       -  
Allocation from shares purchased with loan to ESOP
    -       -       46       -       -       46  
Vesting of Recognition and Retention Plan ("RRP")
    -       -       90       -       -       90  
Stock-based compensation
    -       -       24       -       -       24  
Preferred stock dividends
    -       -       -       (257 )     -       (257 )
Cash dividends declared on common stock
    -       -       -       (300 )     -       (300 )
                                              -  
Balances, March 31, 2010
  $ 28,890     $ 106     $ 54,433     $ 13,130     $ (169 )   $ 96,390  
                                                 
                                                 
                                                 
Balances, January 1, 2011
  $ 20,672     $ 124     $ 63,000     $ 9,663     $ (16 )   $ 93,443  
                                                 
Comprehensive results:
                                               
Net loss
    -       -       -       (891 )     -       (891 )
Other comprehensive results, 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 RRP
    -       -       25       -       -       25  
Stock-based compensation
    -       -       28       -       -       28  
Preferred stock dividends
    -       -       -       (256 )     -       (256 )
Cash dividends declared on common stock
    -       -       -       (114 )     -       (114 )
                                              -  
Balances, March 31, 2011
  $ 20,692     $ 124     $ 63,064     $ 8,382     $ 14     $ 92,276  
 
See accompanying notes to consolidated financial statements.
 
3

 
CITIZENS SOUTH BANKING CORPORATION
           
CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
       
   
Three Months Ended
 
   
March 31, 2011
   
March 31, 2010
 
(Dollars in thousands)
           
             
Cash flows from operating activities:
           
Net income (loss)
  $ (891 )   $ 10,297  
Reconciliation of net income to net cash provided by operating activities:
         
Provision for loan losses
    3,000       3,050  
Depreciation of premises and equipment
    322       260  
Gain on sale of investment securities available for sale
    -       (33 )
(Gain) loss on sale of other assets
    (12 )     62  
(Gain) loss on acquisition
    255       (18,733 )
Valuation adjustment on other real estate owned
    509       484  
Net purchase accounting adjustments - discount accretion
    (2,562 )     -  
Deferred loan origination fees
    60       40  
Amortization of intangible assets
    139       65  
Allocation of shares to the ESOP
    11       46  
Vesting of shares issued for the RRP
    25       90  
Stock-based compensation expense
    28       24  
Decrease in accrued interest receivable
    172       110  
(Increase) decrease in other assets
    (6,020 )     2,387  
Increase (decrease) in other liabilities
    (1,379 )     1,958  
Net cash provided by (used in) operating activities
    (6,343 )     107  
                 
Cash flows from investing activities:
               
Net decrease in loans made to customers
    11,438       4,366  
Net (increase) decrease in loans available for sale
    2,779       (1,650 )
Proceeds from sales of investment securities available for sale
    1,065       9,389  
Proceeds from sales of other real estate owned
    2,347       611  
Proceeds from maturities/issuer calls of investment securities available for sale
    2,175       6,115  
Proceeds from maturities/issuer calls of investment securities held to maturity
    3,103       5,152  
Purchases of investment securities available for sale
    -       (3,853 )
Purchases of investment securities held to maturity
    (48,714 )     (11,025 )
Net cash received in acquisition of Bank of Hiawassee
    -       95,058  
Purchases of premises and equipment
    (125 )     (51 )
Net cash provided by (used in) investment activities
    (25,932 )     104,112  
                 
Cash flows from financing activities:
               
Net decrease in deposits
    (17,653 )     (17,438 )
Cash dividends paid to common stockholders
    (114 )     (300 )
Cash dividends paid to preferred stockholders
    (256 )     (257 )
Issuance of common stock
    -       5,760  
Issuance of preferred stock
    -       8,280  
Net increase (decrease) in borrowed money and repurchase agreements
    (3,032 )     574  
Increase (decrease) in advances from borrowers for insurance and taxes
    188       139  
Net cash used in financing activities
    (20,867 )     (3,242 )
                 
Net increase (decrease) in cash and cash equivalents
    (53,142 )     100,977  
Cash and cash equivalents at beginning of year
    120,899       53,180  
Cash and cash equivalents at end of year
  $ 67,757     $ 154,157  
                 
Supplemental non-cash investing activity:
               
Foreclosed loans transferred to other real estate owned
  $ 4,956     $ 1,514  
 
See accompanying notes to consolidated financial statements.
 
4

 
CITIZENS SOUTH BANKING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  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, 2011 and 2010 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, 2010.

The consolidated financial statements are prepared in accordance with GAAP which require management to make 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 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 subsidiary, Citizens South Financial Services, Inc.  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, 2011, are not necessarily indicative of the results that may be expected for future periods, including the year ending December 31, 2011.

Note 2 - Recent Accounting Pronouncements

A summary of the accounting policies followed by the Company may be found in Note 1 – Summary of Significant Accounting Policies in the 2010 Annual Report on Form 10-K filed with the SEC.  Updates to the significant accounting policies are made as new or revised accounting pronouncements are made. The following paragraphs update that information.

ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures About Fair Value Measurements , requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) a company should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy is required for us beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for us on January 1, 2010.
 
 
5

 
ASU No. 2010-20, Receivables (Topic 310) - Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses requires entities to provide disclosures designed to facilitate financial statement users’ evaluation of (i) the nature of credit risk inherent in the entity’s portfolio of financing receivables, (ii) how that risk is analyzed and assessed in arriving at the allowance for credit losses and (iii) the changes and reasons for those changes in the allowance for credit losses. Disclosures must be disaggregated by portfolio segment, the level at which an entity develops and documents a systematic method for determining its allowance for credit losses, and class of financing receivable.  The required disclosures include, among other things, a roll forward of the allowance for credit losses as well as information about modified, impaired, non-accrual and past due loans and credit quality indicators. ASU 2010-20 was effective for our financial statements as of December 31, 2010, as it relates to disclosures required as of the end of a reporting period. Disclosures that relate to activity during a reporting period were effective January 1, 2011 and had no significant impact on our financial statements.
 
ASU No. 2011-01, Receivables (Topic 310) – Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 temporarily delayed the effective date of the disclosures regarding troubled debt restructurings in ASU No. 2010-20 for public entities.  The effective date will be for interim and annual reporting periods ending after June 15, 2011. Adoption of this standard is not expected to have a significant impact on the Company’s financial statements.

ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring provides additional guidance to clarify when a loan modification or restructuring is considered a troubled debt restructuring (TDR) in order to address current diversity in practice and lead to more consistent application of U.S. GAAP for debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist:  (1) the restructuring constitutes a concession, and (2) the debtor is experiencing financial difficulties. The amendments to Topic 310 clarify the guidance regarding the evaluation of both considerations above. Additionally, the amendments clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a TDR.   This amendment is effective for us July 1, 2011.  Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, we may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. Management is currently evaluating the impact of the adoption of this standard on the Company’s financial statements.
  
ASU No. 2010-28, Intangibles – Goodwill and Other (Topic 350) – When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples in paragraph 350-20-35-30, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  This amendment was effective for us January 1, 2011 and had no impact on our financial statements.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to March 31, 2011. None of these new standards had or is expected to have a material impact on the Company’s consolidated financial statements.
 
 
6

 
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 stockholders 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 stockholders 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.

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 US Treasury. For the three month period ended March 31, 2011, the Company has excluded the 777,313 outstanding options and RRPs from the calculation of diluted earnings per share since the Company incurred a loss during the three-month period ending March 31, 2011.  For the three-month period ended March 31, 2010, options to purchase 797,829 shares were excluded from the calculation of diluted earnings per share because the option exercise price exceeded the average closing price of the shares of common stock during the respective period and, accordingly would have been anti-dilutive. All of the warrants had a strike price in excess of the market value of the stock at March 31, 2011 and March 31, 2010, so no warrants were included in the calculation of diluted earnings per share for either period since they would have been anti-dilutive.

The following is a reconciliation of the diluted earnings (loss) per share calculation for the three months ended March 31, 2011 and 2010:
 
   
Three Months
 
   
Ended March 31,
 
   
2011
   
2010
 
   
(Dollars in thousands, except per share amounts)
 
             
Net income (loss) available to common stockholders
  $ (1,147 )   $ 10,040  
                 
Basic EPS
  $ (0.10 )   $ 1.29  
                 
Shares used in the computation of basic EPS:
               
Weighted average number of shares outstanding
    11,491,734       7,786,819  
                 
Incremental shares from assumed exercise of stock
options and restricted stock
    -       -  
Weighted average number of shares outstanding - diluted
    11,491,734       7,786,819  
                 
Diluted EPS
  $ (0.10 )   $ 1.29  
 
 
7

 
Note 4 – Comprehensive Income (Loss)

Comprehensive income (loss) is the change in the Company’s equity during the period from transactions and other events and circumstances from non-owner sources. Comprehensive income (loss) consists of net income (loss) and other comprehensive income. The Company’s other comprehensive income and accumulated other comprehensive income (loss) are comprised of unrealized gains and losses on certain investment securities. Information concerning the Company’s total comprehensive income (loss) for the three-month periods ended March 31, 2011 and 2010 is as follows:

   
Three Months
 
   
Ended March 31,
 
   
2011
   
2010
 
   
(Dollars in thousands)
 
             
Net income (loss)
  $ (891 )   $ 10,297  
                 
Other comprehensive income:
               
Investment securities, available for sale:
               
Unrealized holding gains arising during period
    49       253  
Tax expense
    (19 )     (98 )
Reclassification for realized gains included in net income
    -       (33 )
Tax benefit
    -       13  
Other comprehensive income
    30       135  
Total comprehensive income (loss)
  $ (861 )   $ 10,432  

 

 
 
8

 
Note 5 – Investment Securities

The carrying values and estimated fair values, as well as unrealized gains and losses of investment securities, available for sale and held to maturity as of March 31, 2011 and December 31, 2010, are detailed below:

         
Gross
   
Gross
       
   
Carrying
   
Unrealized
   
Unrealized
   
Estimated
 
   
Value
   
Gains
   
Losses
   
Fair Value
 
   
(Dollars in thousands)
             
March 31, 2011
                       
Available for sale:
                       
U.S. Government Agency obligations
  $ 19,262     $ 21     $ 108     $ 19,175  
Municipal bonds
    11,550       22       72       11,500  
Mortgage-backed securities
    38,567       207       117       38,657  
Other securities
    1,716       149       80       1,785  
Subtotal
    71,095       399       377       71,117  
                                 
Held to maturity:
                               
U.S. Treasury obligations
    9,960       -       39       9,921  
U.S. Government Agency obligations
    8,998       5       118       8,885  
Mortgage-backed securities
    59,931       712       179       60,464  
Other securities
    4,000       -       85       3,915  
Subtotal
    82,889       717       421       83,185  
                                 
Total at March 31, 2011
  $ 153,984     $ 1,116     $ 798     $ 154,302  
                                 
                                 
           
Gross
   
Gross
         
   
Carrying
   
Unrealized
   
Unrealized
   
Estimated
 
   
Value
   
Gains
   
Losses
   
Fair Value
 
   
(Dollars in thousands)
                 
December 31, 2010
                               
Available for sale:
                               
U.S. Government Agency obligations
  $ 19,297     $ 23     $ 122     $ 19,198  
Municipal bonds
    11,602       40       128       11,514  
Mortgage-backed securities
    40,655       293       175       40,773  
Other securities
    2,781       110       68       2,823  
Subtotal
    74,335       466       493       74,308  
                                 
Held to maturity:
                               
U.S. Treasury obligations
    9,955       -       38       9,917  
U.S. Government Agency obligations
    8,509       4       129       8,384  
Mortgage-backed securities
    14,814       641       37       15,418  
Other securities
    4,000       -       81       3,919  
Subtotal
    37,278       645       285       37,638  
                                 
Total at December 31, 2010
  $ 111,613     $ 1,111     $ 778     $ 111,946  

 
9

 
From time to time the Company will pledge investment securities as collateral to secure public deposits, repurchase agreements, and other borrowings.  The book value of pledged investment securities was $71.4 million at March 31, 2011, and $67.5 million at December 31, 2010.

The unrealized losses and fair value of the investment securities by investment types segregated between those that have been in a continuous unrealized position for less than twelve months and more than twelve months at March 31, 2011 and December 31, 2010, are as follows:

   
Less than 12 months
   
12 months or more
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
   
(Dollars in thousands)
 
March 31, 2011
                                   
Available for sale:
                                   
U.S. Government Agency obligations
  $ 16,061     $ 108     $ -     $ -     $ 16,061     $ 108  
Municipals bonds
    6,400       72       -       -       6,400       72  
Mortgage-backed securities
    10,502       116       104       1       10,606       117  
Other securities
    166       9       101       71       267       80  
   Subtotal
    33,129       305       205       72       33,334       377  
                                                 
Held to maturity:
                                               
U.S. Treasury obligations
    9,920     $ 39     $ -     $ -     $ 9,920     $ 39  
U.S. Government Agency obligations
    5,882       118       -       -       5,882       118  
Municipals bonds
    -       -       -       -       -       -  
Mortgage-backed securities
    30,977       179       -       -       30,977       179  
Other securities
    3,915       85       -       -       3,915       85  
   Subtotal
    50,694       421       0       0       50,694       421  
Total at March 31,2011
  $ 83,823     $ 726     $ 205     $ 72     $ 84,028     $ 798  
                                                 
                                                 
December 31, 2010
                                               
Available for sale:
                                               
U.S. Government Agency obligations
  $ 18,113     $ 122     $ -     $ -     $ 18,113     $ 122  
Municipals bonds
    8,376       128       -       -       8,376       128  
Mortgage-backed securities
    9,395       174       108       1       9,503       175  
Other securities
    0       0       104       68       104       68  
   Subtotal
    35,884       424       212       69       36,096       493  
                                                 
Held to maturity:
                                               
U.S. Treasury obligations
    9,917     $ 38     $ -     $ -     $ 9,917     $ 38  
U.S. Government Agency obligations
    5,881       129       -       -       5,881       129  
Municipals bonds
    -       -       -       -       -       -  
Mortgage-backed securities
    3,049       37       -       -       3,049       37  
Other securities
    3,919       81       -       -       3,919       81  
   Subtotal
    22,766       285       0       0       22,766       285  
Total at December 30,2010
  $ 58,650     $ 709     $ 212     $ 69     $ 58,862     $ 778  

 
10

 
Note 6 - Loans

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

   
March 31, 2011
   
December 31, 2010
 
   
Amount
   
% of Total
Loans
   
Amount
   
% of Total
Loans
 
   
(Dollars in thousands)
             
                         
Real estate:
                       
One-to-four family residential
  $ 140,814       19 %   $ 133,769       18 %
Multifamily residential
    22,330       3 %     23,667       3 %
Construction
    18,983       3 %     20,421       3 %
Land and development
    85,403       12 %     92,724       13 %
Other commercial real estate
    284,569       39 %     286,601       39 %
Consumer real estate
    114,810       16 %     118,021       16 %
Total real estate
    666,909       92 %     675,203       92 %
Commercial business
    46,253       6 %     48,053       7 %
Other consumer
    11,493       2 %     13,254       2 %
Total loans
  $ 724,655       100 %   $ 736,510       100 %
 
The Company does not have any significant loan concentrations, other than those reflected in the preceding table.

The Company has loans covered by FDIC loss-share agreements as a result of the acquisition of Bank of Hiawassee loans. The acquired loans, also referred to as “covered loans,” are covered by two loss-share agreements between the FDIC and the Bank, which afford the Bank significant protection against future loan losses.  Under these loss-share agreements, the FDIC will cover 80% of net loan losses up to $102 million and 95% of net loan losses that exceed $102 million.  The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans 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 represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.  New loans made after the acquisition date are not covered by the FDIC loss-share agreements. These covered loans totaled $137.8 million at March 31, 2011.


 
11

 
The following tables present a breakdown of the Company’s non-covered loan portfolio by payment status, covered loans by payment status and total loan portfolio by payment status at March 31, 2011.

March 31, 2011
 
30 to 89
Days Past
Due
   
90+ Days
Past Due
(Still Accruing)
   
Loans on
Nonaccrual
   
Current
   
Total
Outstanding
 
   
(Dollars in thousands)
 
                               
Not covered by FDIC loss-share agreements
                             
Real estate:
                             
One-to-four family residential
  $ 372     $ -     $ 2,373     $ 106,617     $ 109,362  
Multifamily residential
    -       -       -       20,291       20,291  
Construction
    -       -       72       18,911       18,983  
Land and development
    186       296       11,036       46,809       58,327  
Other commercial real estate
    3,984       -       9,637       220,622       234,243  
Consumer real estate
    1,070       100       909       104,292       106,371  
Total real estate
    5,612       396       24,027       517,542       547,577  
Commercial business
    61       -       309       33,650       34,020  
Other consumer
    19       3       22       5,256       5,300  
Total loans not covered by FDIC loss-
share agreements
  $ 5,692     $ 399     $ 24,358     $ 556,448     $ 586,897  

March 31, 2011
 
30 to 89
Days Past
Due
   
90+ Days
Past Due
(Still Accruing)
   
Loans on
Nonaccrual
   
Current
   
Total
Outstanding
 
   
(Dollars in thousands)
 
                               
Covered by FDIC loss-share agreements
                             
Real estate:
                             
One-to-four family residential
  $ 2,709     $ 84     $ 3,745     $ 24,914     $ 31,452  
Multifamily residential
    -       -       430       1,609       2,039  
Construction
    -       -       -       -       -  
Land and development
    212       -       9,486       17,378       27,076  
Other commercial real estate
    3,358       351       8,840       37,777       50,326  
Consumer real estate
    323       -       264       7,852       8,439  
Total real estate
    6,602       435       22,765       89,530       119,332  
Commercial business
    196       -       1,008       11,029       12,233  
Other consumer
    206       -       183       5,804       6,193  
Total loans covered by FDIC loss-share
agreements
  $ 7,004     $ 435     $ 23,956     $ 106,363     $ 137,758  

 
12

 
 
March 31, 2011
 
30 to 89
Days Past
Due
   
90+ Days
Past Due
(Still Accruing)
   
Loans on
Nonaccrual
   
Current
   
Total
Outstanding
 
   
(Dollars in thousands)
 
                               
Total loans
                             
Real estate:
                             
One-to-four family residential
  $ 3,081     $ 84     $ 6,118     $ 131,531     $ 140,814  
Multifamily residential
    -       -       430       21,900       22,330  
Construction
    -       -       72       18,911       18,983  
Land and development
    398       296       20,522       64,187       85,403  
Other commercial real estate
    7,342       351       18,477       258,399       284,569  
Consumer real estate
    1,393       100       1,173       112,144       114,810  
Total real estate
    12,214       831       46,792       607,072       666,909  
Commercial business
    257       -       1,317       44,679       46,253  
Other consumer
    225       3       205       11,060       11,493  
Total loans
  $ 12,696     $ 834     $ 48,314     $ 662,811     $ 724,655  
 
The following tables present a breakdown of the Company’s non-covered loan portfolio by payment status, covered loans by payment status and total loan portfolio by payment status at December 31, 2010.

December 31, 2010
 
30 to 89
Days Past
Due
   
90+ Days
Past Due
(Still Accruing)
   
Loans on
Nonaccrual
   
Current
   
Total
Outstanding
 
   
(Dollars in thousands)
 
                               
Not covered by FDIC loss-share agreements
                             
Real estate:
                             
One-to-four family residential
  $ 1,299     $ -     $ 1,864     $ 97,851     $ 101,014  
Multifamily residential
    -       -       -       20,674       20,674  
Construction
    630       -       14       19,570       20,214  
Land and development
    2,801       2,000       559       57,527       62,887  
Other commercial real estate
    7,899       -       9,161       217,423       234,483  
Consumer real estate
    1,047       -       2,513       105,634       109,194  
Total real estate
    13,676       2,000       14,111       518,679       548,466  
Commercial business
    61       -       287       34,645       34,993  
Other consumer
    50       -       16       5,409       5,475  
Total loans not covered by FDIC loss-
share agreements
  $ 13,787     $ 2,000     $ 14,414     $ 558,733     $ 588,934  

 
13

 
December 31, 2010
 
30 to 89
Days Past
Due
   
90+ Days
Past Due
(Still Accruing)
   
Loans on
Nonaccrual
   
Current
   
Total
Outstanding
 
   
(Dollars in thousands)
 
                               
Covered by FDIC loss-share agreements
                             
Real estate:
                             
One-to-four family residential
  $ 1,973     $ -     $ 3,468     $ 27,314     $ 32,755  
Multifamily residential
    -       -       -       2,993       2,993  
Construction
    -       -       49       158       207  
Land and development
    549       -       9,904       19,385       29,838  
Other commercial real estate
    2,090       472       9,471       40,084       52,117  
Consumer real estate
    51       37       213       8,526       8,827  
Total real estate
    4,663       509       23,105       98,460       126,737  
Commercial business
    376       17       1,051       11,616       13,060  
Other consumer
    728       -       860       6,191       7,779  
Total loans covered by FDIC loss-share agreements
  $ 5,767     $ 526     $ 25,016     $ 116,267     $ 147,576  
 
December 31, 2010
 
30 to 89
Days Past
Due
   
90+ Days
Past Due
(Still Accruing)
   
Loans on
Nonaccrual
   
Current
   
Total
Outstanding
 
   
(Dollars in thousands)
                   
                               
Total loans
                             
Real estate:
                             
One-to-four family residential
  $ 3,272     $ -     $ 5,332     $ 125,165     $ 133,769  
Multifamily residential
    -       -       -       23,667       23,667  
Construction
    630       -       63       19,728       20,421  
Land and development
    3,350       2,000       10,463       76,912       92,725  
Other commercial real estate
    9,989       472       18,632       257,507       286,600  
Consumer real estate
    1,098       37       2,726       114,160       118,021  
Total real estate
    18,339       2,509       37,216       617,139       675,203  
Commercial business
    437       17       1,338       46,261       48,053  
Other consumer
    778       -       876       11,600       13,254  
Total loans covered by FDIC loss-share agreements
  $ 19,554     $ 2,526     $ 39,430     $ 675,000     $ 736,510  
 
The following table details the Company’s impaired loans at March 31, 2011.

   
Legal Balance
   
Write-down
   
Book Balance
 
   
(Dollars in thousands)
 
                   
One-to-four family residential
  $ 1,084     $ 454     $ 630  
Construction
    247       22       225  
Land and development
    12,610       3,573       9,037  
Other commercial real estate
    11,244       3,693       7,551  
Consumer real estate
    538       387       151  
Total impaired loans
  $ 25,723     $ 8,129     $ 17,594  
 
 
14

 
The following table details the Company’s impaired loans at December 31, 2010.

Note 5 - Impaired Loans
                       
                         
                         
   
Legal Balance
   
Write-down
   
Book Balance
   
Related
Allowance
 
   
(Dollars in thousands)
 
                         
One-to-four family residential
  $ 964     $ 200     $ 764     $ -  
Land and development
    10,982       2,162       8,820       416  
Other commercial real estate
    9,147       3,022       6,125       -  
Consumer real estate
    692       486       206       -  
Total impaired loans
  $ 21,785     $ 5,870     $ 15,915     $ 416  

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 a monthly 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 a well-defined weakness or 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.  Loans not meeting the criteria above as part of the above described process are considered to be pass rated loans.  Loans listed as not rated are included in groups of homogeneous loans.  The Company’s portfolio of FDIC-covered loans was not criticized at March 31, 2011 or December 31, 2010, as the loans were marked to fair value at acquisition and have FDIC loss-share agreements for any potential losses. As of March 31, 2011, and December 31, 2010, and based on the most recent analysis performed, the risk category of loans is as follows:

         
Criticized Loans
       
March 31, 2011
 
Pass
   
Special
Mention
   
Substandard
   
Doubtful
   
Total
Outstanding
 
   
(Dollars in thousands)
 
                               
Real estate:
                             
One-to-four family residential
  $ 107,639     $ 662     $ 1,061     $ -     $ 109,362  
Multifamily residential
    20,020       271       -       -       20,291  
Construction
    18,686       225       72       -       18,983  
Land and development
    33,133       8,815       16,312       67       58,327  
Other commercial real estate
    201,866       9,813       22,564       -       234,243  
Consumer real estate
    103,626       255       2,409       81       106,371  
Total real estate
    484,970       20,041       42,418       148       547,577  
Commercial business
    33,299       408       313       -       34,020  
Other consumer
    5,264       -       36       -       5,300  
Total loans
  $ 523,533     $ 20,449     $ 42,767     $ 148     $ 586,897  


 
15

 
         
Criticized Loans
       
December 31, 2010
 
Pass
   
Special
Mention
   
Substandard
   
Doubtful
   
Total Outstanding
 
   
(Dollars in thousands)
 
                               
Real estate:
                             
One-to-four family residential
  $ 131,072     $ 1,167     $ 1,530     $ -     $ 133,769  
Multifamily residential
    23,394       273       -       -       23,667  
Construction
    18,488       1,933       -       -       20,421  
Land and development
    66,104       10,533       16,012       75       92,724  
Other commercial real estate
    257,770       7,882       20,949       -       286,601  
Consumer real estate
    113,036       1,327       3,523       135       118,021  
Total real estate
    609,864       23,115       42,014       210       675,203  
Commercial business
    47,423       376       254       -       48,053  
Other consumer
    11,200       -       2,054       -       13,254  
Total loans
  $ 668,487     $ 23,491     $ 44,322     $ 210     $ 736,510  

The loans in process of settlement totaled $1.3 million at March 31, 2011, and $4.0 million at December 31, 2010.


 
16

 
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 $137.8 million that are covered under the FDIC loss-share agreements are not included in the Company’s evaluation of the adequacy of loan loss allowances since potential losses are covered up to at least 80% by the FDIC.  These covered loans were recorded at their estimated fair value at the time of the acquisition, resulting in a discount of $46.7 million, or 20.3%, of their contractual balance at the time of the acquisition.  The Company evaluates impairment of its non-covered residential mortgage and consumer loans on a collective basis, while non-covered commercial and construction loans are evaluated individually for impairment.  The Company identifies a non-covered loan as impaired when it is probable that principal and interest will not be collected according to the contractual terms of the loan agreement.

Specific allowances or principal write-downs are established for certain individual non-covered loans that management considers impaired.  These loans are detailed in Note 6 – Loans of this report.  The remainder of the portfolio of non-covered loans is segmented into groups of loans with similar risk characteristics for evaluation and analysis. Management’s periodic evaluation of the allowance is consistently applied and based on inherent losses in the portfolio, past loan loss experience, risks inherent in the different types of loans, the estimated value of any underlying collateral, current economic conditions, the borrower’s financial position, and other relevant internal and external factors that may affect loan collectibility. The allowance for loan losses is increased by charging provisions for loan losses against income.  As of March 31, 2011, the allowance for loan losses was $12.0 million, or 2.05% of total non-covered loans.  Management believes that this amount meets the requirement for losses on loans that management considers to be impaired, for known losses, and for losses inherent in the remaining non-covered loan portfolio.  Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations.

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

     
Three Months
 
     
Ended March 31,
 
     
2011
   
2010
 
     
(Dollars in thousands)
 
               
Balance - Beginning of period
  $ 11,924     $ 9,189  
Add:
Provision for loan losses
    3,000       3,050  
 
Loan recoveries
    118       50  
Less:
Loan charge-offs
    3,036       3,059  
Balance - End of period
  $ 12,006     $ 9,230  


 
17

 
Note 8 – Deposits

Deposit balances are detailed by category as follows for the respective periods:

   
March 31, 2011
   
December 31, 2010
 
   
(Dollars in thousands)
 
             
Noninterest-bearing demand
  $ 78,342     $ 70,056  
Interest-bearing demand
    169,482       172,414  
Money market deposit
    142,307       142,538  
Savings
    17,565       17,004  
Time deposits
    425,107       448,444  
Total deposits
  $ 832,803     $ 850,456  

Note 9 – 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 that include both fixed and variable rates at the respective periods are as follows:
 
   
March 31, 2011
   
December 31, 2010
 
   
(Dollars in thousands)
 
             
Loan commitments
           
Residential mortgage loans
  $ 16,841     $ 14,530  
Non-residential mortgage loans
    5,225       2,500  
Commercial loans
    545       731  
Consumer loans
    1,053       765  
Total loan commitments
  $ 23,664     $ 18,526  
                 
Unused lines of credit
               
Commercial
  $ 14,909     $ 13,000  
Consumer
    75,963       73,655  
Total unused lines of credit
  $ 90,872     $ 86,655  
                 
Undisbursed Construction Loan Proceeds
  $ 1,088     $ 524  


 
18

 
Note 10 – Fair Value Measurements

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures.  The Company has not elected the fair value option for liabilities.  Investment securities, available for sale, are recorded at fair value on a recurring basis.  Additionally, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans and other real estate owned.  These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting for these other assets.

In accordance with ASC 825-10, when measuring fair value, the Company uses valuation techniques that are appropriate and consistently applied.  A fair value hierarchy is used based on the markets in which the assets are traded and the reliability of the assumptions used to determine the fair value.  These levels are as follows:
 
Level 1: Inputs to the valuation methodology are based on quoted prices in active markets for identical instruments.

Level 2: Inputs to the valuation methodology are derived from readily available pricing sources for market transactions involving similar types of instruments in active markets.
 
Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

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

Investment SecuritiesInvestment 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.  Securities valued using Level 3 include equity securities that are not traded on an active exchange, investments in closely held subsidiaries, and asset-backed securities traded in less liquid markets.

Loans - The Company does not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. 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. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2011 and December 31, 2010, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with ASC 825-10, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price, the Company records the impaired loan 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 impaired loan as nonrecurring Level 3.

 
19

 
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 impaired loan as nonrecurring Level 3.

Assets Recorded at Fair Value on a Recurring Basis:
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
    (Dollars in thousands)  
March 31, 2011
                       
Investment securities, available for sale
  $ -     $ 69,733     $ 1,384     $ 71,117  
Investment securities, held for sale
    9,960       72,929       -       82,889  
Investment securities, rabbi trusts
    -       280       -       280  
                                 
December 31, 2010
                               
Investment securities, available for sale
  $ -     $ 71,285     $ 3,023     $ 74,308  
Investment securities, held for sale
    9,955       27,323       -       37,278  
Investment securities, rabbi trusts
    -       731       -       731  
                                 
Assets Recorded at Fair Value on a Nonrecurring Basis:
                               
                                 
March 31, 2011
                               
Presold loans in process of settlement
  $ -     $ 1,255     $ -     $ 1,255  
Impaired loans
    -       -       17,594       17,594  
Other real estate owned
    -       -       16,584       16,584  
                                 
December 31, 2010
                               
Presold loans in process of settlement
  $ -     $ 4,034     $ -     $ 4,034  
Impaired loans
    -       -       15,916       15,916  
Other real estate owned
    -       -       14,652       14,652  
 
Note 11 - Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  The estimates are significantly affected by the assumptions used, including discount rates and estimates of future cash flows.  These estimates may differ substantially from amounts that could be realized in an immediate sale or settlement of the instrument.

Fair value approximates book value for the following financial instruments due to their short-term nature: cash and due from banks, interest-earning bank balances, and advances from customers for taxes and insurance.  Fair value for investment securities are based mainly on valuation methodology derived from readily available pricing sources for market transactions involving similar types of instruments in active markets.  Fair value for variable rate loans that reprice frequently is based on the carrying value reduced by an estimate of credit losses inherent in the portfolio.  Fair value for all other loans is estimated by discounting their future cash flows using interest rates currently being offered for loans of comparable terms and credit quality.
 
Fair value for demand deposit accounts and interest-bearing deposit accounts with no fixed maturity is equal
 
 
20

 
to the carrying value.  Certificate of deposit fair values are estimated by discounting cash flows from expected maturities using interest rates currently being offered for similar instruments with comparable terms. Fair value approximates book value for short-term repurchase agreements.  For borrowed money, fair value is calculated based on discounted cash flows using current interest rates.

At March 31, 2011 and December 31, 2010, 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, 2011 and December 31, 2010, the carrying amounts and fair values of these off-balance sheet financial instruments were immaterial.

The Company has used management’s best estimates of fair values of financial instruments based on the above assumptions.  This presentation does not include certain financial instruments, nonfinancial instruments or certain intangible assets such as customer relationships, deposit base intangibles, or goodwill.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The estimated fair values of financial instruments at the respective dates were as follows:

   
March 31, 2011
   
December 31, 2010
 
   
Carrying
   
Estimated
   
Carrying
   
Estimated
 
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
   
(Dollars in thousands)
 
Financial assets:
                       
Cash and due from banks
  $ 10,398     $ 10,398     $ 15,110     $ 15,110  
Interest-earning bank balances
    57,359       57,359       105,789       105,789  
Investment securities
    154,006       154,302       111,586       111,946  
Federal Home Loan Bank stock
    5,715       5,715       5,715       5,715  
Presold loans in process of settlement
    1,255       1,255       4,034       4,034  
Net loans receivable
    724,655       740,848       736,510       751,219  
Accrued interest receivable
    2,829       2,829       3,001       3,001  
Bank-owned life insurance
    18,386       18,386       18,230       18,230  
                                 
Financial liabilities:
                               
Demand deposits
    247,824       247,824       242,470       242,470  
Money market accounts
    142,307       142,307       142,538       142,538  
Savings
    17,565       17,565       17,004       17,004  
Time deposits
    425,107       427,982       448,444       451,853  
Securities sold under repurchase agreements
    11,389       11,389       9,432       9,432  
Borrowed money
    96,257       103,618       101,246       109,092  

 
21

 
Note 12 – Subsequent Events

FDIC-Assisted Acquisition.  On April 15, 2011, Citizens South Bank executed a Purchase and Assumption Agreement with the FDIC to acquire substantially all of the assets and assume substantially all of the liabilities of New Horizons Bank, which was headquartered in its one office located in East Ellijay, Georgia.  With this transaction, the Bank now has 21 full-service offices and has increased assets to over $1.1 billion.

 Under the terms of the transaction, the Bank acquired $107.6 million in assets, including $76.1 million in loans, and assumed $101.9 million in deposits.  Substantially all of the acquired loans are covered by two loss-share agreements between the FDIC and the Bank (also referred to as “covered loans”).  Under these loss-share agreements the FDIC will cover 80% of net losses of any covered loan or covered other real estate owned property. Management is currently working with a third party to determine the fair value of the acquired assets and assumed liabilities.  Based on preliminary results, the Company expects that this transaction will result in a $2.9 million gain on acquisition and will add from $0.04 to $0.05 in additional annualized earnings per share after integration.

Dividend Declaration.  On April 25, 2011, 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 stockholders of record as of May 9, 2011, payable on May 23, 2011. The Company has paid cash dividends in each of the 52 quarters since the Company’s conversion to public ownership.



 
22

 
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, and 6) adverse legal, regulatory or accounting changes and other risk factors described under Item 1A. “Risk Factors” of the Company’s 2010 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.

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.

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, NOW, 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
 
 
23

 
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, 2011 and 2011.  Readers seeking a more in-depth analysis should read the detailed discussions below, as well as the consolidated financial statements and related notes.  Financial highlights for the comparable periods are presented in the following table.

Quarterly Financial Highlights (unaudited)
 
At and For the Quarters Ended
 
   
2011
   
2010
 
   
March 31
   
December 31
   
September 30
   
June 30
   
March 31
 
(Dollars in thousands, except per share data)
                             
                               
Summary of Operations:
       
 
   
 
   
 
   
 
 
Interest income - taxable equivalent
  $ 10,457     $ 11,055     $ 11,675     $ 12,308     $ 9,210  
Interest expense
    2,855       3,411       3,790       4,083       3,393  
   Net interest income - taxable equivalent
    7,602       7,644       7,885       8,225       5,817  
Less: Taxable-equivalent adjustment
    70       70       79       114       98  
   Net interest income
    7,532       7,574       7,806       8,111       5,719  
Provision for loan losses
    3,000       5,000       3,000       3,000       3,050  
Net interest income after loan loss provision
    4,532       2,574       4,806       5,111       2,669  
Noninterest income
    1,478       2,274       2,290       2,415       20,185  
Noninterest expense
    7,672       7,918       7,781       7,279       6,356  
   Net income (loss) before income taxes
    (1,662 )     (3,070 )     (685 )     247       16,498  
Income tax expense (benefit)
    (771 )     (1,331 )     (413 )     (108 )     6,201  
   Net income (loss)
    (891 )     (1,739 )     (272 )     355       10,297  
Dividends on preferred stock
    256       256       256       257       257  
   Net income (loss) available to common shareholders
  $ (1,147 )   $ (1,995 )   $ (528 )   $ 98     $ 10,040  
                                         
Per Common Share Data:
                                       
Net income:
                                       
  Basic
  $ (0.10 )   $ (0.18 )   $ (0.05 )   $ 0.01     $ 1.29  
  Diluted
    (0.10 )     (0.18 )     (0.05 )     0.01       1.29  
Weighted average shares outstanding:
                                       
  Basic
    11,491,734       11,173,174       10,844,386       9,077,042       7,786,819  
  Diluted
    11,491,734       11,173,174       10,844,386       9,077,042       7,786,819  
End of period shares outstanding
    11,508,750       11,508,750       10,964,146       10,965,941       9,125,942  
Cash dividends declared
  $ 0.01     $ 0.01     $ 0.04     $ 0.04     $ 0.04  
Book value
    6.22       6.32       6.86       6.91       7.39  
Tangible book value
    6.09       6.17       6.70       6.73       7.16  
                                         
Selected End of Period Balances:
                                       
Total assets
  $ 1,041,444     $ 1,064,487     $ 1,087,558     $ 1,077,431     $ 1,132,652  
Loans, net
    724,655       736,510       754,740       776,234       787,643  
Investment securities
    154,006       111,586       87,255       97,678       100,161  
Deposits
    832,803       850,456       865,786       853,526       884,127  
Shareholders' equity
    92,276       93,443       95,682       96,410       96,390  
                                         
Selected Quarterly Average Balances:
                                       
Total assets
  $ 1,053,747     $ 1,075,338     $ 1,080,680     $ 1,105,788     $ 873,418  
Loans, net
    726,346       747,054       767,381       780,209       599,826  
Investment securities
    135,645       100,691       91,361       100,501       89,020  
Deposits
    841,387       853,185       853,902       859,408       614,007  
Shareholders' equity
    93,533       94,761       96,258       96,282       78,292  
                                         
Selected Financial Performance Ratios (annualized):
                                       
Return on average assets
    -0.44 %     -0.74 %     -0.20 %     0.04 %     4.66 %
Return on average common equity
    -6.39 %     -10.68 %     -2.77 %     0.56 %     73.21 %
Noninterest income to average total assets  (1)
    0.56 %     0.85 %     0.85 %     0.87 %     9.24 %
Noninterest expense to average total assets (2)
    2.91 %     2.95 %     2.88 %     2.63 %     2.91 %
Efficiency ratio  (1) (2)
    84.49 %     79.83 %     76.47 %     68.41 %     24.44 %
 
24

 
Quarterly Financial Highlights (unaudited)
 
At and For the Quarters Ended
 
   
2011
   
2010
 
   
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
    4.62 %     4.68 %     4.91 %     4.96 %     5.02 %
Cost of funds
    1.32 %     1.51 %     1.66 %     1.72 %     2.01 %
Net Interest spread
    3.30 %     3.17 %     3.25 %     3.24 %     3.01 %
Net interest margin (taxable equivalent)
    3.42 %     3.25 %     3.42 %     3.48 %     3.22 %
                                         
Credit Quality Information and Ratios:
                                       
Past due loans (30-89 days) accruing - non-covered
  $ 5,692     $ 13,787     $ 6,602     $ 10,145     $ 7,003  
Past due loans - non-covered to total non-covered loans
    0.97 %     2.34 %     1.11 %     1.68 %     1.15 %
                                         
Past due loans (30-89 days) accruing - covered by FDIC loss-
share (3)
  $ 7,006     $ 5,767     $ 8,701     $ 5,257     $ 11,030  
Past due loans - covered to total covered loans
    5.09 %     3.91 %     5.43 %     3.07 %     6.09 %
                                         
Allowance for loan losses - beginning of period
  $ 11,924     $ 10,752     $ 9,796     $ 9,230     $ 9,189  
Add: Provision for loan losses
    3,000       5,000       3,000       3,000       3,050  
Less: Net charge-offs
    2,918       3,828       2,044       2,433       3,009  
Allowance for loan losses - end of period
    12,006       11,924       10,752       9,797       9,230  
 
                                       
Allowance for loan losses to total non-covered loans
    2.05 %     2.02 %     1.81 %     1.62 %     1.52 %
Net charge-offs to average non-covered loans (annualized)
    1.99 %     2.59 %     1.36 %     1.61 %     1.98 %
Nonperforming non-covered loans to non-covered loans
    4.15 %     2.79 %     3.33 %     2.15 %     2.26 %
Nonperforming non-covered assets to total assets
    3.15 %     2.26 %     2.61 %     1.97 %     1.78 %
Nonperforming non-covered assets to total non-covered loans
and other real estate owned
    5.51 %     4.03 %     4.71 %     3.46 %     3.30 %
                                         
Nonperforming Assets:
                                       
Nonperforming non-covered loans:
                                       
One-to-four family residential
  $ 2,373     $ 1,864     $ 2,068     $ 1,646     $ 1,618  
Construction
    72       14       163       896       443  
Acquisition and development
    4,675       2,560       340       691       2,890  
Commercial land
    4,653       4,360       5,034       3,252       6,148  
Other commercial real estate
    9,636       4,800       9,566       4,127       1,422  
Commercial business
    309       287       720       742       131  
Consumer
    2,639       2,529       1,930       1,652       1,083  
Total nonperforming non-covered loans
    24,357       16,414       19,821       13,006       13,735  
Total nonperforming loans covered by FDIC loss-share (4)
    24,391       25,541       22,416       24,924       18,148  
Other real estate owned - non-covered
    8,463       7,650       8,557       8,239       6,462  
Other real estate owned - covered by FDIC loss-share
    8,121       7,002       3,183       2,343       933  
Total nonperforming assets
  $ 65,332     $ 56,607     $ 53,977     $ 48,512     $ 39,278  
                                         
Capital Ratios:
                                       
Tangible common equity
    6.73 %     6.69 %     6.74 %     6.86 %     5.78 %
Total Risk-Based Capital (Bank only)
    16.70 %     16.80 %     16.83 %     16.78 %     15.53 %
Tier 1 Risk-Based Capital (Bank only)
    15.44 %     15.54 %     15.58 %     15.52 %     14.47 %
Tier 1 Total Capital (Bank only)
    9.89 %     9.74 %     9.58 %     9.74 %     9.18 %
 

(1)
Includes the gain on acquisition of Bank of Hiawassee of $18.7 million for the quarter ended March 31, 2010.  Subsequent adjustments in the amounts of $605,000, $193,000, $148,000 and ($255,000) were made for the quarters ended June 30, 2010, September 30, 2010, December 31, 2010, and March 31, 2011, respectively.
(2)
Includes acquisition and integration expenses of $787,000, $94,000, $141,000, $42,000 and $45,000 for the quarters ended March 31, 2010, June 30, 2010, September 30, 2010, December 31, 2010, and March 31, 2011, respectively.
(3)
The contractual balance of past due loans covered by  FDIC loss-share agreements totaled $13.8 million, $6.4 million, $14.8 million, $7.0 million and $7.7 million at March 31, 2010, June 30, 2010, September 30, 2010, December 31, 2010, and March 31, 2011, respectively.
(4)
The contractual balance of nonperforming loans covered by  FDIC loss-share agreements totaled $29.0 million, $35.4 million, $29.1 million, $31.2 million and $28.7 million at March 31, 2010, June 30, 2010, September 30, 2010, December 31, 2010, and March 31, 2011 respectively.
 
25

 
Critical Accounting Policies

The accounting and financial policies of the Company and its subsidiaries are prepared in accordance with accounting principles generally accepted in the United States and conform to general practices in the banking industry.  We consider accounting policies that require 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 Bank’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 of Securities. The Company reviews all investment securities with significant declines in fair value for potential other-than-temporary impairment on a periodic basis. The Company records an impairment charge when it believes an investment has experienced a decline in value that is other than temporary.  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.  However, such declines in value that are due to the underlying credit quality of the issuer or other adverse conditions that cannot be expected to improve in the foreseeable future, may be considered to be other than temporary. 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 the March 19, 2010, FDIC-assisted acquisition of Bank of Hiawassee and the related FDIC loss-share receivable involved a high degree of judgment and complexity.  The carrying value of the acquired loans and the FDIC receivable reflect management’s best estimate based on information available at the time of the acquisition.  The amount we actually receive on these loans could differ materially from the carrying value reflected in the financial statements based upon the timing and collections on the acquired loans in the future.  To the extent that actual values realized for the acquired loans are different from the initial estimates, the FDIC loss-share receivable will generally be impacted in an offsetting manner due to the nature of the FDIC loss-share agreements.  On April 15, 2011, the Bank acquired New Horizons Bank in an FDIC-assisted transaction.  The initial fair value of these newly acquired loans and the related FDIC loss-share receivable will also involve a high degree of judgment and complexity.



 
26

 
Comparison of Financial Condition for the Periods Ended March 31, 2011 and December 31, 2010

Assets.  Total assets of the Company decreased by $23.0 million, or 2.2%, from $1.1 billion at December 31, 2010, to $1.0 billion at March 31, 2011.  This decrease was primarily due to a reduction of excess liquidity that was used to fund maturing time deposits.
 
Total cash and cash equivalents, which include cash and due from banks and interest-earning bank balances, decreased by $53.1 million, or 44.0%, from $120.9 million at December 31, 2010, to $67.8 million at March 31, 2011. This decrease in cash and cash equivalents was primarily attributable to the purchase of $48.7 million of investment securities and the funding of $26.3 million of maturing time deposits during the three-month period.  The Company’s excess liquidity was held in the Company’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, 2011, loans receivable decreased by $11.9 million, or 1.6%, to $724.7 million at March 31, 2011.  This decrease in loans was primarily due to the Company’s continuing efforts to reduce exposures in its construction, residential acquisition and development, and non-owner occupied commercial real estate portfolios coupled with reduced loan demand. 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 $24.3 million during the first three months of 2010 to $29.4 million during the first three months of 2011.  The Company’s expansion into the North Georgia market will allow us to geographically diversify our loan portfolio.  Although the North Georgia market has sustained significant decreases in real estate values over the past two and a half 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 condition.

During the three-month period ended March 31, 2011, investment securities increased by $42.4 million, or 38.0%, to $154.0 million.  The increase was due to the purchase of $48.7 million in investment securities, held to maturity.  These investment securities were primarily U.S. Government agency mortgage-backed securities that provide for monthly cash flow that can be reinvested in higher-yielding loans when loan demand strengthens. During the three-month period ended March 31, 2011, the Company sold $1.0 million of investment securities and experienced normal maturities and principal amortization of $5.3 million. The investment security that was sold during the period was a subordinated debenture that had previously been determined to have an other-than-temporary impairment due to credit concerns relating to the issuer.  The Company has no further exposure to this issuer.  Management expects the investment portfolio to increase as a percentage of total assets over the next 12 months as the Bank’s excess liquidity is invested in higher-yielding assets.

Other real estate owned, which includes all properties acquired by the Company through foreclosure, totaled $16.6 million at March 31, 2011, compared to $14.7 million at December 31, 2010.   Of the $16.6 million in other real estate owned at March 31, 2011, $8.1 million is covered by FDIC loss-share agreements.  The remaining $8.5 million of non-covered other real estate owned is comprised of $1.1 million of one-to-four family residential dwellings, $894,000 of commercial real estate, and $6.5 million of developed residential lots and undeveloped land.  All foreclosed properties are written down to their estimated fair value (market value less estimated disposition costs) at acquisition and are located in the Bank’s primary lending area.  Management will continue to aggressively market foreclosed properties for a timely disposition.

 
27

 
During the first quarter of 2011, premises and equipment decreased by $198,000, or 0.8%, to $23.6 million.  This decrease was primarily due to normal depreciation of $322,000 on the Company’s premises and equipment.  This depreciation was partly offset by the purchase of $125,000 in furniture and equipment during the quarter.  In the second quarter of 2011, the Company plans to consolidate the operations of its supermarket store branch with its Hiawassee full-service branch office.  These two offices are located on the same street, so customer interruption is expected to be minimal.

Liabilities. Total liabilities decreased by $21.8 million, or 2.3%, from $971.0 million at December 31, 2010, to $949.2 million at March 31, 2011.  This decrease was primarily due to a reduction of time deposits during the three-month period.

During the first three months of 2011, total deposits decreased by $17.7 million, or 2.1%, to $832.8 million at March 31, 2011. The change in deposits was primarily due to a $26.3 million decrease in time deposits during the quarter.  The decrease in time deposits was partly due in the maturity of $4.8 million of out-of-market internet deposits that were not renewed.  The remaining internet deposits totaled $1.8 million at March 31, 2011.  In addition, management has focused on increasing deposits by building customer relationships and typically avoided growing deposits by offering the highest rates in the market, especially for single product customers.

Total core deposits increased by $8.7 million, or 2.2%, to $410.7 million at March 31, 2011.  This core deposit growth included an $8.3 million increase in non-interest bearing demand deposits, a $2.8 million increase in money market accounts, and a $561,000 increase in savings accounts.   We believe our core deposit growth was partly due to a flight to safety as funds moved from weaker financial institutions as well as a continued emphasis on increasing the Company’s retail and business customers through employee incentive plans and enhanced treasury service products.

During the first quarter of 2011 borrowed money decreased by $5.0 million, or 4.9%, to $96.2 million at March 31, 2011.  This decrease was primarily due to the maturity of $5.0 million of Federal Home Loan Bank advances during the period.  The Company plans to use excess liquidity to repay these borrowings as they mature.  From time to time additional borrowed money may be used to fund additional loan growth, or to purchase investment securities.

Shareholders’ Equity.  Total shareholders’ equity decreased by $1.2 million, or 1.3%, from $93.4 million at December 31, 2010, to $92.3 million at March 31, 2011.  This decrease was primarily due the net loss of $891,000 during the quarter and the payment of $114,000 in cash dividends on common stock and $256,000 in cash dividends on preferred stock.

Comparison of Results of Operations for the Three Months Ended March 31, 2011 and 2010

General.  Net loss available to common stockholders for the three months ended March 31, 2011, amounted to $1.1 million, or ($0.10) per diluted share, as compared to net income available to common stockholders of $10.0 million, or $1.29 per diluted share, for the three months ended March 31, 2010.  This change was largely related to the acquisition of Bank of Hiawassee which contributed to an $18.7 million pre-tax gain on the acquisition of Bank of Hiawassee for the three month period ended March 31, 2010.

Net interest income.  Net interest income increased by $1.8 million, or 31.7%, to $7.5 million for the first quarter of 2011 as compared to $5.7 million for the first quarter of 2010. The Company’s net interest margin increased by 20 basis points to 3.42% for the quarter ended March 31, 2011, compared to 3.22% for the quarter ended March 31, 2010.  This increase in the net interest margin was primarily the result of the cost of funds falling at a faster rate than the yield on assets.

Interest income increased by $1.3 million, or 14.0%, to $10.4 million for the first quarter of 2011.  This increase was primarily due to a $170.0 million increase in average interest-earning assets during the comparable quarters to $902.1 million for the first quarter of 2011.  This increase was largely due to the acquisition of Bank of Hiawassee on March 19, 2010.  The positive effect of the increase in interest-earning assets was partly offset by a 40 basis point decrease in the average yield on earning assets during the respective periods to 4.62% for the quarter ended March 31, 2011. The decrease in yield was largely due to lower market rates and higher levels of lower-yielding liquid assets held during the first quarter of 2011.

Interest expense decreased by $538,000, or 15.9%, for the comparable periods to $2.9 million for the first quarter of 2011.  This decrease in interest expense was largely due to lower market interest rates, which resulted in a 69 basis point decrease in the average cost of funds to 1.32% for the quarter ended March
 
 
28

 
31, 2011.  The decrease in cost of funds offset the $206.1 million increase in the average interest-bearing liabilities to $878.5 million for the first quarter of 2011.  This change included a $205.8 million increase in average interest-bearing deposits and a $267,000 increase in average borrowings, largely due to the acquisition.
 
Provision for loan losses.  Due to continued weakness in the local economy and an increase in nonperforming assets, the Company’s provision for loan losses amounted to $3.0 million for the first quarter of 2011 compared to $3.1 million for the first quarter of 2010.  As a result, the allowance for loan losses was $12.0 million, or 2.05% of total non-covered loans, as of March 31, 2011, compared to $9.2 million, or 1.52% of total non-covered loans, as of March 31, 2010.  While the Company’s credit quality continues to compare favorably with Southeast peer banks, the continued decline in local economic conditions has resulted in an upward trend in the Company’s level of nonperforming loans. The Company’s ratio of nonperforming non-covered assets to total assets increased from 1.78% at March 31, 2010, to 3.19% at March 31, 2011. A substantial portion of the Company’s nonperforming non-covered loans at March 31, 2011, was secured by real estate located in the Company’s normal lending market.  Net chargeoffs of non-covered loans totaled $2.9 million, or 1.99% of average non-covered loans annualized, during the first quarter of 2011 compared to $2.9 million, or 1.98% of average non-covered loans annualized, during the first quarter of 2010. Management expects that the Company will continue to experience larger than normal loan loss provisions for the next several quarters.
 
Noninterest income.  Noninterest income decreased by $18.7 million to $1.5 million for the three months ended March 31, 2011, as compared to $20.2 million for the three months ended March 31, 2010. The primary reason for the decrease was the $18.7 million gain from the acquisition of Bank of Hiawassee in the first quarter of 2010.  The following table presents the detail for the three-month periods ending March 31, 2011, and March 31, 2010.
 
   
Three Months Ended
       
   
March 31, 2011
   
March 31, 2010
   
Variance
 
   
(Dollars in thousands)
 
Noninterest income:
                 
Service charges on deposit accounts
  $ 957     $ 799     $ 158  
Mortgage banking income
    237       210       27  
Commissions on sales of financial products
    67       118       (51 )
Income from bank-owned life insurance
    182       189       (7 )
Gain (loss) from acquisition
    (255 )     18,733       (18,988 )
Gain on sale of investments, available for sale
    -       33       (33 )
Gain (loss) on sale of other assets
    12       (62 )     74  
Other income
    278       165       113  
Total noninterest income
  $ 1,478     $ 20,185     $ (18,707 )

Most of the increases in noninterest income were largely attributable to the acquisition of Bank of Hiawassee.  Service charges on deposit accounts were higher due to the increased number of demand deposit accounts which generate monthly service charges and non-sufficient (“NSFs”) funds fees on overdrafts. However, legislation limiting the assessment of NSF fees from overdrafts generated from debit cards in 2010 has had an adverse impact on fee income on deposit accounts.  However, the Company has successfully worked to lessen the negative impact of this legislation by asking customers to “opt-in” to allowing overdrafts on their debit cards.  Mortgage banking income was higher in the first quarter of 2011 due to increased origination activity arising from decreases in long-term residential loan interest rates in 2011. Commissions on sales of financial products were lower in 2011 largely due to decreased activity and reduced staffing.  Income from bank-owned life insurance decreased slightly due to lower market rates.  The gain on acquisition in the first quarter of 2010 was the initial $18.7 million gain that was booked at acquisition.
 
 
29

 
This gain may be adjusted for a period of up to one year from the acquisition date as additional information about the fair value of the assets acquired and liabilities assumed is received. As such, the gain was adjusted lower during the first quarter of 2011.  No further adjustments to the gain on acquisition are expected since we have now passed the one year anniversary of the acquisition.  The gain on sale of investments was lower during the first quarter of 2011, due to the fact that there were fewer investments sold at a gain as compared to the first quarter of 2010.  During the first quarter of 2011, the Company sold $1.0 million in investment securities compared to the sale of $9.4 million in investment securities during the first quarter of 2010.  The gain on sale of other assets was higher due to losses from sale of foreclosed properties recognized during the first quarter of 2010.  Other income increased primarily due an increase in rental income on other real estate owned, increased safe deposit box rental income, and other miscellaneous items.
 
Noninterest expense.  Noninterest expense increased by $1.3 million, or 20.7%, to $7.7 million for the quarter ended March 31, 2011.  The following table presents the detail of noninterest expense for the three-month periods ending March 31, 2011 and March 31, 2010.
 
   
Three Months Ended
       
   
March 31, 2011
   
March 31, 2010
   
Variance
 
   
(Dollars in thousands)
 
Noninterest Expense:
                 
Compensation and benefits
  $ 3,648     $ 2,643     $ 1,005  
Occupancy and equipment
    828       683       145  
Office supplies
    70       41       29  
Advertising and business development
    54       57       (3 )
Professional services
    253       234       19  
Telephone and communications
    97       72       25  
Data processing
    183       140       43  
Deposit insurance
    334       260       74  
Amortization of intangible assets
    139       65       74  
Valuation adjustment on other real estate owned
    509       484       25  
Acquisition and integration expenses
    45       787       (742 )
Other expenses
    1,512       890       622  
Total noninterest expense
  $ 7,672     $ 6,356     $ 1,316  
 
The primary reason for the increases in noninterest expense was the acquisition and integration of Bank of Hiawassee, which extended the Company’s geographic footprint to North Georgia, added five full-service offices, and added $229.9 million of loans covered by FDIC loss-share agreements.  Compensation and benefits increased due to the increased number of employees resulting from the Bank of Hiawassee acquisition. These additional employees primarily included branch personnel, troubled asset officers, FDIC loss-share specialists and other support positions.  Occupancy and equipment expense also increased due to the acquisition of Bank of Hiawassee which added five branch offices (four owned and one leased) and an operations center.  The Company purchased the existing owned branch offices and related equipment from the FDIC in 2010.  However, the Company did not purchase the operations center, which was vacated in the third quarter of 2010. Increases in office supplies, professional services, telephone and communications, data processing, and deposit insurance were directly related to the additional offices, personnel and customers that resulted from the acquisition. Amortization of intangible assets was higher due to the amortization expense related to the $1.6 million core deposit intangible that was created as a result of the acquisition.  This intangible asset is being amortized over an eight-year period using the accelerated method.  The increased number of foreclosed properties and the lower real estate values resulted in the increased valuation adjustment on other real estate owned.  Acquisition and integration expenses were lower since a large portion of the conversion and integration expenses were incurred in 2010.  Other expenses increased primarily as a result of higher collection costs and expenses associated with the Company’s other real estate owned.  These expenses include the payment of attorney fees, delinquent taxes, insurance, and maintenance.

 
30

 
Income taxes.  The Company recognized an income tax benefit of $771,000 for the quarter ended March 31, 2011, compared to a tax expense of $6.2 million for the quarter ended March 31, 2010.  The decrease in the tax expense was due to the pre-tax loss in the first quarter of 2011 compared to the pre-tax income in the first quarter of 2010.

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, 2011, the Company’s cash and cash equivalents totaled $67.8 million.  Of this amount, $55.3 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 $89.5 million available to draw from its line of credit with the FHLB.  The FHLB functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB, we are required to own capital stock in the FHLB and we are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities that are obligations of, or guaranteed by, U.S. Government Agencies, or Government Sponsored Enterprises) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. 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 June 30, 2011, and is used for the purpose of providing daily liquidity as needed by the Company.  Outstanding advances made under this facility are generally repaid on a daily basis at a rate determined by PCBB based on their marginal cost of funds.  Advances are limited to not more than 10 consecutive days at a time.  The Company also has an unsecured federal funds accommodation with CenterState Bank of Florida in the amount of $5.0 million.  The credit facility, which is used to fund short-term liquidity needs, may be 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, 2011, the Company had no outstanding brokered deposits and $1.8 million of internet deposits that were assumed from the acquisition of Bank of Hiawassee.  These internet deposits have not been 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, 2011, the Company had loan commitments of $23.7 million, unused lines of credit of $90.9 million, and undisbursed construction loan proceeds of $1.1 million.  See Note 9 – Commitments for additional details. The Company also has various leases in place to provide office space for four full-service offices and one in-store office.  The cost of these leases for 2010 was $614,000.  Management does not expect any material changes in the amount of the leases over the next five years. Short-term borrowings totaled $13.4 million at March 31, 2011.  These short-term borrowings consisted of $11.4 million of daily securities sold under repurchase agreements and $2.0 million of FHLB advances that mature over the next 12 months. The Company does not have any special purpose entities or other similar forms of off-balance-sheet financing. The Company believes that given its current level of internal and external sources of liquidity, it has adequate resources to fund loan commitments and lines of credit, repay short-term borrowing if necessary, and any fund any other normal obligations that may arise in the near future.

 
31

 
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, 2011, 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)
  $ 111,007       16.70 %   $ 66,477       10.00 %
Tier 1 capital (to risk-weighted assets)
    102,628       15.44 %     39,886       6.00 %
Tier 1 capital (to adjusted total assets)
    102,628       9.89 %     51,877       5.00 %
Tangible capital (to adjusted total assets)
    102,628       9.89 %     31,126       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, 2010.
 
Item 4.  Controls and Procedures

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

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

Item 1. Legal Proceedings

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

Item 1A.  Risk Factors

There have been no material changes to the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
 
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, 2011.

Item 6. Exhibits

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

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

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

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

 
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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 13, 2011
By:
/s/ Kim S. Price
 
 
 
Kim S. Price
 
 
President and Chief Executive Officer
       
       
Date: May 13, 2011
By:
/s/ Gary F. Hoskins
 
 
 
Gary F. Hoskins
 
 
Executive Vice President, Chief Financial Officer and Treasurer
 
 
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