On October 8, 2004, First Citizens acquired Financial National Electronic Transfer, Inc. (“FiNET”), a data processing company that specializes in the processing of federal benefit payments and military allotments, headquartered in Radcliff, Kentucky.  Effective January 1, 2005 FiNET was merged into First Citizens. These services are now operated using the name of FirstNet.

On November 2, 2006, First Citizens announced the signing of a definitive agreement to acquire the military allotment operation of PNC Bank, National Association based in Elizabethtown, Kentucky. The operation specializes in the processing of data associated with military allotments and federal benefit payments. The transaction was completed on January 12, 2007 and merged into First Citizens and its FirstNet operations.

Based on total bank deposits in Hardin County, First Citizens ranks third in size compared to all banks operating in Hardin County.  Total assets were $296$316 million and total deposits were $250$269 million at December 31, 2010.2011.

On December 6, 2005, the Company acquired Citizens Bancorp in Newport, Kentucky.  Citizens Bancorp was subsequently merged into Citizens Acquisition, a former bank holding company subsidiary of the Company. During January 2007, Citizens Acquisition was merged into the Company, leaving Citizens Northern as a direct subsidiary of the Company. Citizens Northern is a state chartered bank organized in 1993 and is engaged in a general banking business providing full service banking to individuals, businesses, and governmental customers.  It conducts business in its principal office in Newport and four branches in Campbell County, Kentucky, one branch in Boone County, Kentucky and two branches in Kenton County, Kentucky. Based on total bank deposits in Campbell County, Citizens Northern ranks third in size compared to all banks operating in Campbell County.  At year-end 20102011 it had total assets and deposits of $250$256 million and $201$205 million, respectively. Citizens Financial Services, formerly an investment brokerage subsidiary of Citizens Acquisition, was dissolved during 2006.

In March 2008 Citizens Northern incorporated ENKY Properties, Inc. (“ENKY”). ENKY was established to manage and liquidate certain real estate properties repossessed by Citizens Northern. In addition, ENKY holds a 17% interest in NUBT, the parent company of Flowing Creek. Flowing Creek holds real estate that has been repossessed by Citizens Northern and United Bank along with parties unrelated to the Company. NUBT holds a 67% interest in Flowing Creek and unrelated financial institutions hold the remaining 33% interest. ENKY had total assets of $1.1 million$847 thousand at year-end 2010.

FCB Services, organized in 1992, provides data processing services and support for the Company and its subsidiaries.  It is located in Frankfort, Kentucky. It also performs data processing services for nonaffiliated entities.  FCB Services had total assets of $3.2$3.8 million at December 31, 2010.2011.

Kentucky General was incorporated in November 2004. Kentucky General2004 and previously held a 50% voting interest in KHL Holdings prior to its sale during the third quarter of 2009.  KHL Holdings owned a 100% interest in KHL Insurance that it acquired in 2005. KHL Insurance writeswas a writer of credit life and health insurance in Kentucky. Kentucky General was dissolved during 2010.

EKT was created in September 2008 to manage and liquidate certain real estate properties repossessed by the Company’s subsidiary banks. On December 31, 2010,2011, EKT had total assets of $4.1$3.6 million.

Kentucky General Life Insurance Company was incorporated during 2000 to engage in insurance activities permitted by federal and state law.  This corporation has remained inactive since its inception and was dissolved during 2010.

Trust I, Trust II, and Trust III are each separate Delaware statutory business trusts sponsored by the Company.  The Company completed two private offerings of trust preferred securities during 2005 through Trust I and Trust II totaling $25.0

A significant part of the Company’s operating activities include originating loans, approximately 87%88% of which are secured by real estate at December 31, 2010.2011.  Real estate lending primarily includes loans secured by owner and non-owner occupied one-to-four family residential properties as well as commercial real estate mortgage loans to developers and owners of other commercial real estate.  Real estate lending primarily includes both variable and adjustable rate products.  Loan rates on variable rate loans generally adjust upward or downward immediately based on changes in the loan’s index, normally prime rate as published in the Wall Street Journal.  Rates on adjustable rate loans move upward or downward after an initial fixed term of normally one, three, or five years. Rate adjustments on adjustable rate loans are made annually after the initial fixed term expires and are indexed mainly to shorter-term Treasury indexes.  Generally, variable and adjustable rate loans contain provisions that cap the amount of interest rate increases over the life of the loan of up to 600 basis points and lifetime floors of 100 basis points. In addition to the lifetime caps and floors on rate adjustments, loans secured by residential real estate typically contain provisions that limit annual increases at a maximum of 100 basis points. There is typically no annual limit applied to loans secured by commercial real estate.

The Company also makes fixed rate commercial real estate loans to a lesser extent with repayment termsperiods generally not exceeding 12 months.ranging from three to five years.  The Company’s subsidiary banks make first and second residential mortgage loans secured by real estate not to exceed 90% loan to value without seeking third party guarantees.  Commercial real estate loans are made primarily to small and mid-sized businesses, secured by real estate not exceeding 80% loan to value.  Other commercial loans are asset based loans secured by equipment and lines of credit secured by receivables and include lending across a diverse range of business types.

Commercial lending and real estate construction lending, including commercial leasing, generally includes a higher degree of credit risk than other loans, such as residential mortgage loans.  Commercial loans, like other loans, are evaluated at the time of approval to determine the adequacy of repayment sources and collateral requirements.  Collateral requirements vary to some degree among borrowers and depend on the borrower’s financial strength, the terms and amount of the loan, and collateral available to secure the loan.  Credit risk results from the decreased ability or willingness to pay by a borrower.  Credit risk also results when a liquidation of collateral occurs and there is a shortfall in collateral value as compared to a loan’s outstanding balance.  For construction loans, inaccurate initial estimates of a project’s costs and the property’s completed value could weaken the Company’s position and lead to the property having a value that is insufficient to satisfy full payment of the amount of funds advanced for the property.  Secured and unsecured direct consumer loanslending generally areis made for automobiles, boats, and other motor vehicles.  The Company does not presently engage in indirect consumer lending. Credit card lending is limited to one affiliate and is considered nominal risk exposure due to extremely low volume. In most cases loans are restricted to the subsidiaries' general market area.

The lending policy lists the products and credit services offered by each of the Company’s subsidiary banks.   Each product and service has an established written procedure to adhere to when transacting business with a customer.   The lending policy also establishes pre-determined lending authorities for loan officers commensurate with their abilities and experience.  Further, the policy establishes committees to review and approve or deny credit requests at various lending amounts.  This includes subcommittees of the bank boards of directors and, at certain lending levels, the entire bank board.

Generally, for loans in excess of $1$2.5 million, the bank subsidiaries bank’s full board of directors will be presented with the loan request. This only occurs when the potential credit has first been recommended by the loan officer and chief credit officer of the subsidiary bank, and then by the directors’ loan committee.committee and the Chief Credit Officer.  When loan requests are within policy guidelines and the amount requested is within their lending authority, lenders are permitted to approve and close the transaction.  A review of the loan file and documentation takes place within 30 days to ensure policy and procedures are being followed.  Approval authorities are under regular review for adjustment by affiliate management and the parent company.Parent Company.  Loan requests outside of standard policy may be made on a case by case basis when justified, documented, and approved by the board of directors of the subsidiary bank.

Underwriting criteria for all types of loans are prescribed within the lending policy.

Residential real estate mortgage lending makes up the largest portion of the loan portfolio.  The outstanding balancesbalance in this classification, of loans have been stable, representing roughly one-thirdas a percentage of the portfolio, has increased in eachrecent years from approximately one third to 42% of the previous five-year period. This component of the loan portfolio has experienced the least amount of delinquency and charge offs within the affiliated banks.portfolio.

A valuation allowance to offset credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred losses in the remainder of the portfolio at the balance sheet date.  Management estimates the allowance balance required using past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. Actual losses could differ significantly from the amounts estimated by management.

Each basis point is equal to one hundredth of one percent.  Basis points are calculated by multiplying percentage points times 100. For example:  3.7 percentage points equals 370 basis points.

Net income (loss) divided by average shareholders’ equity. Measures the relative profitability of the shareholders' investment in the Company.

Income from tax-exempt loans and investment securities have been increased by an amount equivalent to the taxes that would have been paid if this income were taxable at statutory rates. In order to provide comparisons of yields and margins for all earning assets, the interest income earned on tax-exempt assets is increased to make them fully equivalent to other taxable interest income investments.

The following pages present management’s discussion and analysis of the consolidated financial condition and results of operations of Farmers Capital Bank CorporationCorporations (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY, First Citizens Bank (“First Citizens”) in Elizabethtown, KY, United Bank & Trust Company (“United Bank”) in Versailles, KY, and its significantCitizens Bank of Northern Kentucky, Inc. in Newport, KY (“Citizens Northern”). At year-end 2011, Farmers Bank had two wholly-owned subsidiaries, Leasing One Corporation (“Leasing One”) and Farmers Capital Insurance Corporation (“Farmers Insurance”). Leasing One is a commercial leasing company in Frankfort, KY, and Farmers Insurance is an insurance agency in Frankfort, KY. The Lawrenceburg Bank and Trust Company, which previously was a separate bank subsidiary of the Parent Company, was merged into Farmers Bank on May 8, 2010; First Citizens Bank in Elizabethtown, KY; United Bank & Trust Company (“United Bank”) in Versailles, KY which, during 2008, was the surviving company after the merger with two sister companies of Farmers Bank and Trust Company (“Farmers Georgetown”) and Citizens Bank of Jessamine County; United Bank had one subsidiary at year-end 2010,2011, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank; and Citizens Bank of Northern Kentucky, Inc. in Newport, KY (“Citizens Northern”);Bank. Citizens Northern had one subsidiary at year-end 2010,2011, ENKY Properties, Inc. ENKY Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.

The Company has three active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”), FFKT Insurance Services, Inc. (“FFKT Insurance”), and EKT Properties, Inc. (“EKT”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT was created in 2008 to manage and liquidate certain real estate properties repossessed by the Company. In addition, the Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation.

This report contains forward-looking statements with the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties.  Statements in this report that are not statements of historical fact are forward-looking statements. In general, forward-looking statements relate to a discussion of future financial results or projections, future economic performance, future operational plans and objectives, and statements regarding the underlying assumptions of such statements.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.

The Company’s forward-looking statements are based on information available at the time such statements are made. The Company expressly disclaims any intent or obligation to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events, or other changes.

The Company’s audited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices applicable to the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility from period to period. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.

The most significant accounting policies followed by the Company are presented in Note 1 of the Company’s 20102011 audited consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this management’s discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, fair value measurements, and accounting for goodwill to be the accounting areas that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

The carrying value of certain financial assets and liabilities of the Company is impacted by the application of fair value measurements, either directly or indirectly.  Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as investment securities classified as available for sale.  In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established.  

The Company estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. The Company characterizes active markets as those where transaction volumes are sufficient to provide objective pricing information, with reasonably narrow bid/ask spreads, and where received quoted prices do not vary widely. When the financial instruments are not actively traded, other observable market inputs such as quoted prices of securities with similar characteristics may be used, if available, to determine fair value. Inactive markets are characterized by low transaction volumes, price quotations that vary substantially among market participants, or in which minimal information is released publicly.

When observable market prices do not exist, the Company estimates fair value primarily by using cash flow and other financial modeling methods. The valuation methods may also consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations, and unexpected correlations can affect estimates of fair value. Changes in these underlying factors, assumptions, or estimates in any of these areas could materially impact the amount of revenue or loss recorded.

 

Additional information regarding fair value measurements can be found in Notes 1 and 1918 of the Company’s 20102011 audited consolidated financial statements.  The following is a summary of the Company’s more significant assets that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by the Company:

Investment securities classified as available for sale are measured and reported at fair value on a recurring basis. Available for sale investment securities are valued primarily by independent third party pricing services under the market valuation approach that include, but are not limited to, the following inputs:

At December 31, 2010,2011, all of the Company’s available for sale investment securities were measured using observable market data.

 

Other real estate owned (“OREO”) includes properties acquired by the Company through actual loan foreclosures and is carried at fair value less estimated costs to sell. Fair value of OREO is based on third party appraisals of the property that includes comparable sales data comprised of significant unobservable inputs. If the carrying amount of the OREO exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. At December 31, 20102011 OREO was $30.5$38.2 million compared to $31.2$30.5 million at year-end 2009.2010.

Loans are considered impaired when full payment under the contractual terms is not expected. Impaired loans are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral based on recent appraisals if the loan is collateral dependent. If the value of an impaired loan is less than the unpaid balance, the difference is credited to the allowance for loan losses with a corresponding charge to provision for loan losses. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of a loan is confirmed.

Appraisals used in connection with valuing collateral dependent loans may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments are usually significant and typically include significant unobservable inputs for determining fair value. Impaired loans were $130$138 million and $108$130 million at year-end 20102011 and 2009,2010, respectively.

The Company offers a variety of financial products and services at its 36 banking locations in 23 communities throughout Central and Northern Kentucky. The Company has four separately chartered commercial banks that operate under a community banking philosophy. This philosophy is focused primarily on understanding the banking needs and providing competitively priced products and a high level of personalized service to those in the local communities and surrounding areas in which the Company operates. The most significant products and services the Company offers include consumer and commercialbusiness lending, receiving deposits,checking, savings, and other deposit accounts, automated teller machines, and providing trust services and offeringamong other traditional banking products and services. The primary goals of the Company are to continually improve profitability and shareholder value, increase and maintain a strong capital position, provide excellent service to our customers through our community banking structure, and to provide a challenging and rewarding work environment for our employees.

The Company generates a significant amount of its revenue, cash flows, and net income from interest income and net interest income, respectively.income. Interest income is generated by earnings on the Company’s earning assets, primarily loans and investment securities. Net interest income is the excess of the interest income earned on earning assets over the interest expense paid on amounts borrowed to support those

Managing credit risk, or the risk of loss due to customers or other counterparties not being able to meet their financial obligations under agreed upon terms, is also a factor that can significantly influence the operating results of the Company. The severe downturn in financial markets and in the overall economy during 2008 and into 2009 created unprecedented market volatility. During that time, certain capital markets ceased to function and credit markets were unavailable to many businesses and consumers. In response, theThe U.S. government tookhas taken extraordinary steps to stabilize financial markets by enacting broad legislation and regulatory initiatives that included the largest stimulus plan in its history. ImprovementImprovements in the U.S. financial markets and the overall economy have since occurred, during 2010.albeit in irregular intervals and at a moderate pace. However, certain key metrics such as high unemployment and lowerfalling real estate values persist. This has had a significant negative effect on the Company’s operations in the form of elevated nonperforming loans, allowance for loan losses, and net loan charge-offs.

Following is a summary ofSummarized below are the moremost significant issues and events that impacted the CompanyCompany’s operations during 20102011 and that will continueare likely to have an impact beyond 2010:in the future.

The Company reported net income of $2.7 million or $.11 per common share for 2011 compared to a $6.9 million or $.68 per common share in 2010 compared tofor 2010. This represents a net lossdecrease of $44.7$4.2 million or $6.32$.57 per common share. Selected income statement amounts and related data are presented in the table below.

The $4.2 million or $.57 per common share decrease in net income for 2009. This represents an improvement2011 compared to the 2010 is primarily the result of $51.7lower overall noninterest income of $9.7 million or $7.00 per common share. The prior year net loss was mainly attributed to a one-time $46.5 million after tax non-cash goodwill charge representing the Company’s write off of its entire previously reported goodwill.